Economics N. Gregory Mankiw. A Macroeconomic Theory of the Open Economy. Introduction. In this chapter, look for the answers to these questions

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1 Seventh Edition Pinciples of Economics N. Gegoy Mankiw CHAPTER 32 A Macoeconomic Theoy of the Open Economy In this chapte, look fo the answes to these questions 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? 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

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: So, demand fo loanable funds = The Maket fo Loanable Funds Recall: S depends positively on the eal inteest ate,. I depends negatively on. What about? How Depends on the Real Inteest Rate The eal inteest ate,, is the eal etun on domestic assets. A fall in Net capital outflow

3 The Loanable Funds Maket Diagam Loanable funds S = saving LF 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. A C T I V E L E A R N I N G 1 Answes Loanable funds Net capital outflow LF

4 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, 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. The Maket fo Foeign-Cuency Exchange An incease in E makes U.S. goods moe expensive to foeignes,

5 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: The peson needs to sell he dollas to obtain the foeign cuency she needs to buy the impots. 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. 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: The foeigne needs dollas in ode to puchase the U.S. asset. 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 C T I V E L E A R N I N G 2 Budget deficit, exchange ate, 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?

6 A C T I V E L E A R N I N G 2 Answes Maket fo foeigncuency exchange The Twin Deficits Pecent of GDP 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% U.S. fedeal budget deficit U.S. net expots SUMMARY: The Effects of a Budget Deficit National saving falls. The eal inteest ate ises.

7 SUMMARY: The Effects of a Budget Deficit One othe effect: Due to many yeas of budget and tade deficits, Intenational Investment Position of the U.S. 31 Octobe 2013 Value of U.S.-owned foeign assets Value of foeign-owned U.S. assets U.S. net debt to the est of the wold $21.6 tillion $25.8 tillion $ 4.2 tillion The Connection Between Inteest Rates and Exchange Rates Anything that inceases 1 E 1 S 1 = 1 E 1 1 D = NX dollas 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

8 A C T I V E L E A R N I N G 3 Answes Loanable funds Net capital outflow LF A C T I V E L E A R N I N G 3 Answes Maket fo foeigncuency exchange E Dollas Budget Deficit vs. Investment Incentives A tax incentive fo investment has simila effects as a budget deficit: But one impotant diffeence: Investment tax incentive Budget deficit

9 Tade Policy Tade policy: Examples: Taiff Impot quota Voluntay expot estictions Tade Policy Common easons fo policies that estict impots: 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. Analysis of a Quota on Cas fom Japan An impot quota Loanable funds Net capital outflow S 1 1 D LF

10 Analysis of a Quota on Cas fom Japan Maket fo foeigncuency exchange E S = E 1 D 1 Dollas 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 Since NX must equal, Hence, Analysis of a Quota on Cas fom Japan Does the policy save jobs? The quota educes impots of Japanese autos. But

11 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.: 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. Political Instability and Capital Flight People woied about the safety of Mexican assets they owned. People sold many of these assets, pulled thei capital out of Mexico. Capital flight: We analyze this using ou model, but fom the pespective of Mexico, not the U.S. Capital Flight fom Mexico Loanable funds Net capital outflow S D 1 LF 1

12 Capital Flight fom Mexico Maket fo foeigncuency exchange E S 1 = 1 E 1 D 1 Pesos Examples of Capital Flight: Mexico, US Dollas pe cuency unit /23/ /12/ /2/ /22/1994 1/11/1995 1/31/1995 2/20/1995 3/12/1995 4/1/1995 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.

13 CONCLUSION Yet, we should be caeful not to blame ou poblems on the intenational economy. When politicians and commentatos discuss intenational tade and finance, the lessons of this and the peceding chapte can help sepaate myth fom eality.