Macroeconomics II. The Open Economy

Transcription

1 Macroeconomics II The Open Economy Vahagn Jerbashian Ch. 5 from Mankiw (2010, 2003) Spring 2018

2 Where we are and where we are heading to So far we have considered closed economy no trade with other countries no imports and exports interest rate equates the investments and savings Today we will open the economy to foreign trade and discuss the importance of international trade and its determinants see how the national accounts identity reflects the international trade

3 International trade The international trade allows having more goods and services from which to choose opportunities to invest wealth (and/or diversify the risks) In developed countries, exports and imports tend to be higher than the 10% of GDP In developed countries, international trade tends to be central to economic policy design and analysis of economic developments

4 The international flows of capital and goods The key difference between closed and open economy is that the latter can spend more (less) than it produces by borrowing (lending) from (to) foreigners To see this we will take a closer look on the National Accounts Identity (NAI) Borrowing (lending) from (to) abroad creates a link between investments and savings in a country and its exports and imports NAI will also show this

5 The role of net exports - NAI Let C d and C f be the consumption of domestic and foreign goods and services. Similarly, define I d, I f and G d, G f as the investment and government purchases of domestic and foreign goods and services, respectively. Thus, C = C d + C f ; I = I d + I f ; G = G d + G f The total output of the economy is ( ) ( ) ( ) Y = C C f + I I f + G G f + EX = C + I + G + EX (C ) f + I f + I f C + I + G + EX IM

6 The role of net exports - NAI, borrower/lender The net exports is defined as exports minus imports NX }{{} net exports = EX IM = }{{} Y (C + I + G) }{{} output domestic spending When the economy produces more (less) than it spends it lends (borrows) to (from) foreigners and the NX is positive (negative) The NX shows the trade balance. When it is zero the trade is balanced; positive (negative) there is trade surplus (deficit)

7 International capital flows and the trade balance In a closed economy the savings are equal to investments, S = I. This is not necessarily the case in an open economy. Consider again the NAI of a country, NX = Y (C + I + G ) = (Y T C ) + (T G ) I = S I S I is called Net Capital Outflow or Net Foreign Investment

8 International capital flows and the trade balance (S-I) When S I > (<) 0 the country lends (borrows) to (from) abroad Therefore, S I is the total lending to abroad minus the total borrowing from abroad It reflects the international flows of resources to finance capital accumulation The NAI shows then that the international flow of funds to accumulate capital and flow of goods and services are two sides of the same coin, NX = S I

9 Saving and investment in small open economy So far we have seen how the international trade is reflected in national accounts identity; the variables that can measure the international trade (e.g., exports, net capital flow) We will now develop a model that will help to explain the international trade and suggest its determinants Since net flow of capital and net exports are the same, we will focus on the former (S I )

10 Important remarks Before we proceed, some important remarks: 1. In open economy, the world interest rate equilibrates the total (world) savings and investments 2. Small open economy does not affect the world interest rate r. It takes r as given 3. The interest rate in small open economy is equal to world interest rate, r = r

11 Saving and investment in small open economy - The model Let 1. factor inputs (K, L), taxes (T ) and government expenditure (G ) be fixed; 2. consumption (C ) be positively related to personal disposable income (Y T ); and 3. investment (I ) be negatively related to interest rate (r ). From these assumptions and NAI follows that NX = S I (r ) S = (Y T C ) + (T G ) = const

12 Saving and investment in small open economy - The model The identity NX = S I (r ) states that the trade balance is determined from the difference of savings and investments at the world interest rate On a graph

13 The effect of policies on NX - Domestic fiscal policy Let the government expand its spending or decrease the taxes From S = (Y T C ) + (T G ) C (Y T ) follows that S G and S T, and "more" investment should be funded by borrowing, thus NX declines On a graph...

14 The effect of domestic fiscal policy on trade balance

15 The effect of policies on NX - Fiscal policy abroad The change in fiscal policy of a small open economy has a negligible impact on total savings, thus on the world interest rate r The change in fiscal policy in big open economies can shift the total savings and thus change r When a big economy increases its G or decreases T the total savings decline; thus, the world interest rate (r ) increases When r increases borrowing becomes more costly and the domestic investment declines in the small open economy Given the S fixed the small open economy starts investing abroad more; thus, the NX increases On a graph...

16 The effect of foreign fiscal policy on trade balance

17 What is the exchange rate? Thus far we have discussed the international flows of capital and goods and services Now we will discuss the prices that apply to these transactions The exchange rate between two countries is the price at which the residents of those countries trade with each other

18 Nominal and real exchange rates 1. The nominal exchange rate (NER) is the relative price of the currency of two countries e.g., 1 EUR = $1.30; 1 EUR = 24 CZK 2. The real exchange rate (RER) is relative price of the goods of two countries e.g., an apple in Spain 1 EUR; the same in the Czech Republic 12 CZK (0.5 EUR) RER is sometimes called the terms of trade since it shows the rate at which the goods of one country are traded for the goods of another country

19 The relation between nominal and real exchange rates In order to see the relation of between NER and RER lets consider the following example: Suppose that Spanish apple costs 1 EUR and Czech apple costs 12 CZK In order to compare the prices of these apples we have to have common currency. By using NER, we will have that Spanish apple costs twice more than Czech apple; or one can exchange two Czech apples for one Spanish apple RER = (24CZK /EUR) (1EUR/Spanish apple) (12CZK /Czech apple) Czech apple = 2 Spanish apple

20 The relation between NER and RER in general case In general RER is determined by prices and NER RER = NER (Price of domestic good) (Price of foreign good) NER P P Given NER, if the RER is high (low), then foreign goods are relatively cheap (expensive) and home made goods relatively expensive (cheap)

21 RER and the trade balance Remember that RER is the relative price of goods between countries When RER is high (low) the foreign goods are cheaper (more expensive); thus more (less) attractive and consumed more (less) Therefore, when RER is high (low) the trade balance NX is low (high) since imports are high (low) and exports are low (high) Formally, NX = NX (RER) NX RER.

22 How is RER determined? From national accounts identity follows that NX = S I The savings S depend on domestic factors (output, fiscal policy variables, etc) The investments I is determined by the world interest rate r. Therefore, we have that NX = S I (r ) Given that S and I are determined, RER adjusts to ensure that On a graph... NX (RER) = S I (r )

23 How is RER determined? You can think of this diagram as representing the supply and demand for foreign currency exchange S I line is the net capital outflow or the supply of EUR to be exchanged to foreign currency and invested NX line is the net demand of EUR from foreigners who buy Spanish goods

24 How policies affect the RER - Domestic fiscal policy Let the government expand its spending or decrease the taxes We have seen already that in such case both net capital flows (S I ) and net exports decline (NX ) On a graph... The RER adjusts (increases) to ensure that NX declines The RER increases since the supply of domestic currency (S I ) decreases and the domestic currency becomes more valuable

25

26 How policies affect the RER - Fiscal policy abroad Let the government of a big country expand its spending or cut the taxes We have seen already that in such case the world interest rate increases (r ); thus, the investments (I ) decline and net capital flows (S I ) increase On a graph... The RER adjusts (decreases) to ensure that NX increases The RER decreases since the supply of domestic currency (S I ) increases and the domestic currency becomes less valuable

27

28 The determinants of NER - 1 For NER we have that NER = RER From this it follows that RER P P Price of foreign good Price of domestic good % change in NER = % change in RER +% change in P % change in P = % change in RER + π π

29 The determinants of NER - 2 Consider, for instance, Spain and the Czech Republic. The expression % change in NER = % change in RER + π π tells that if in the Czech Republic ("abroad") inflation is higher than in Spain then the EUR will buy increasing amount of CZK over time

30 Purchasing power parity The hypothesis called law of one price states that the same good cannot sell for different prices at different locations at the same time This hypothesis in international marketplace is called purchasing power parity. It states that if an international arbitrage is possible, then EUR (or any other currency) must have the same purchasing power in every country i.e., EUR cannot buy more apples in the Czech Republic than in Spain, otherwise it would be profitable to buy apples in the Czech Republic and sell them in Spain