Macroeconomics I International Group Course 2004-2005 Topic 7: SAVINGS AND INVESTMENT IN THE OPEN ECONOMY Learning objectives We now start the study of the open economy. This brings into the analysis of how an economic system works some additional markets and relative prices. In particular, the domestic economy can trade in goods and financial assets with the rest of the world and the decisions about where to buy or where to invest depend mostly on two relative prices: the interest rate differential and the real exchange rate. To facilitate the exposition, we proceed along the same steps as in the closed economy. In this topic we consider an open economy in the long run: all prices are flexible (the supply curve is vertical). Thus we look mainly at the determination of savings and investment. In the next topic we will look at the determination of aggregate demand in the open economy when domestic prices are sticky. 1 2
Learning objectives We have already studied the goods and services and the money market equilibrium in a closed economy. With some modifications we can use these conditions to study the open economy. Recall that in the long run all markets clear and the aggregate supply does not respond to changes in the price level. Thus changes in aggregate demand do not have any effect on output. The supply side of the economy is affected by openness: The rate of technological progress (A) is stimulated by transfers of know-how and ideas across countries. Productive capital (K) is also reallocated across countries. Firms move in search of a better economic environment and higher profits. Migrations alter the amount of labor available in an economy (L) and the labor market at large. Learning objectives However, we shall leave these supply side effects aside and focus primarily on the effects that openness has on the demand side of the economy. These effects are: There is a new component of aggregate demand: net exports (exports minus imports). Investment can be financed by domestic or foreign saving. Households and firms may now hold their wealth both in domestic and in foreign assets. Since the demand side is enlarged, the link between savings and investment is now different. This is what we shall study next. 3 4
Aggregate demand in the open economy Total expenditure in the open economy is given by: d d d Y = C + I + G + EX C d : spending by domestic households on goods and services produced at home. I d : spending by domestic firms on new capital goods produced at home. G d : public spending on goods and services produced at home. EX: total exports of goods and services produced at home. Aggregate demand in the open economy We can rewrite this expression in a way that resembles what we had in the closed economy. Let us define: C m : spending by domestic households on goods and services produced abroad. I m : spending by domestic firms on new capital goods produced abroad. G m : public spending on goods and services produced abroad. Total consumption, investment and public spending are defined as: Consumption: C= C d +C m Investment: I= I d +I m Public spending: G= G d +G m 5 6
Aggregate demand in the open economy Savings, investment and the trade balance Rearranging terms, m m m Y = ( C C ) + ( I I ) + ( G G ) + EX m m m Y = C+ I + G+ EX ( C + I + G ) Y = C+ I + G+ EX IM As we know, there is a close link between goods markets and financial markets. Total income in the domestic country has three uses: Y = C+ S+ T While, total expenditure is given by: Y = C+ I + G+ XN Aggregate demand equals total domestic spending (in goods and services produced at home and abroad) plus net exports (exports minus imports) Y = C+ I + G+ XN Then, in equilibrium, the following condition must hold: I + G+ XN = S+ T 7 8
Savings, investment and the trade balance As such, equilibrium implies: I = S+ T G XN Domestic investment (I) can be financed by raising funds from public domestic savings (T-G), private savings (S) as well as from foreign savings (-XN). A VERY IMPORTANT REMARK: The amount of savings that an economy is able to attract in the foreign financial markets equals minus net exports. If a country is running a trade deficit (XN<0) it is being financed by foreign funds, while an economy with a trade surplus is financing the rest of the world. Savings, investment and the trade balance To see this, let us write: S + ( T G) I = XN The difference between total domestic savings (private plus public: S+(T-G)) and domestic investment (I) is the amount of funds the country s residents can lend abroad. This amount equals net exports (XN). If the excess of domestic savings is positive it means that we are providing funds to the rest of the world. The rest of the world is using our funds to buy our goods in excess of what they sell to us, thus the country with excess savings is running a trade deficit. If we have a trade balance surplus (XN>0), we are lending abroad (S+(T-G)>0) and we shall get the returns from our lending in the future. If our trade balance is negative (XN<0), then we are borrowing from abroad because we have a shortage of savings (S+(T-G)<0), and we shall have to pay the interest on our borrowing in the future. 9 10
The macroeconomics of the open economy So far we have presented the basic identities of the open economy. These can also be understood as the equilibrium conditions of a macroeconomic model that explains how the main variables are determined in the open economy. We shall still assume the same relationships for the variables we had in the closed economy: C = C( Y T) I = Ir () G = G The macroeconomics of the open economy In the open economy the model is slightly different: 1) the interest rate does not depend on the domestic economic conditions. Since all agents, domestic and foreign, can lend and borrow anywhere in the world, the interest rates cannot permanently differ across countries. 2) net exports are a component of aggregate demand. Thus aggregate demand will respond to whatever variables affect imports and exports. Let us discuss these new features in turn. 11 12
Perfect capital mobility and interest rates Let us assume that international investors can trade assets in any market without restrictions ( perfect capital mobility ). Then anybody investing in, say, European bonds will have to get a return that is at least equal to what she can obtain elsewhere (the international interest rate, r) plus a premium to compensate for realignments in the nominal exchange rate (she will have to buy euros today to buy European bonds and then change the return in euros back into dollars to consume abroad) plus an additional premium associated to the specific risk of investing in Europe, as compared with investing elsewhere. r = r + dep. + riesgo To simplify matters we shall assume throughout that both the exchange rate and the risk premia are zero. Then the following arbitrage condition must hold: r = r We shall assume further that the domestic economy is small enough that it does not influence the world interest rate. Thus r is exogenous. How big is a small open economy? Not all economies in the world fit well the description of a small open economy. Japan, the U.S. and the E.M.U. are big enough that their economic policies and domestic shocks can have an influence on the world interest rate. The macroeconomics of a large open economy differs from that of a small open one in one single feature: if the economy is large enough the relevant interest rate is no longer exogenous. Domestic investment and financial decisions taken in the large economy depend on the real interest rate, but this is not independent of developments in this economy. In a way, the study of the large open economy is very similar to that of the closed economy. After all, the largest open economy is the world as a whole, which is itself a closed economy. Thus, the study of the small open economy is most interesting because it takes us beyond the closed economy case. In this and in the next topics we shall concentrate on this case. 13 14
The trade balance (net exports) We call the difference between exports and imports net exports. What we export will increase with income abroad (Y) and fall with the relative price of our goods, while domestic imports will rise with our income (Y) as well as with the relative prices of the domestic goods. The relative price of our domestic goods is called the real exchange rate (ε). XN = XN( Y, Y, ε) In the long-run neither Y nor Y are affected by developments in the demand side. Thus we shall assume them to be exogenous and we shall focus on the determination of the real exchange rate. Thus. We may write: XN = XN( Y, Y, ε) = XN( ε) The real exchange rate When a US resident is considering buying a European car she must take into account two relative prices: The price of the European car in euros (P) with the price of a comparable American car in dollars (P) How many dollars she has to pay to purchase the amount of euros needed to buy the car. The appropriate comparison has to be made in the same currency, thus we must consider the price in euros of the American car (ep) relative to the price in euros of the European car (P). This is what we call the real exchange rate, which is the product of two relative prices: the nominal exchange rate and the relative price of domestic goods. ε = e P P $ ( ) ( ) ( $ ) 15 16
The nominal exchange rate The nominal exchange rate (e) is the relative price of the currency in two countries. For instance, the euro/dollar nominal exchange rate tells us how many (e) dollars we must pay to buy one euro or how many euros (1/e) we are given for one dollar. Variations in the nominal rate: e rises: the euro appreciates vis-a-vis the dollar (the dollar depreciates vis-a-vis the euro) if the amount of dollars I have to pay to buy a euro rises (the amount of euros I am given for one dollar falls). e falls: the euro depreciates vis-a-vis the dollar (the dollar appreciates vis-a-vis the euro), if the amount of dollars I have to pay to buy a euro falls (the amount of euros I am given for one dollar rises). e($) e = 1( ) Next exports and the real exchange rate A high real exchange rate means that domestic goods are expensive relative to foreign goods. This may be due either to: High domestic prices in euros (P). Low foreign prices in dollars (P). Euros are expensive relative to dollars (e). Net exports fall as the real exchange rate rises XN = XN( ε) 17 18
Equilibrium in the open economy Full open economy model Equilibrium real interest rate Y = Y = F( K, L) C = C( Y T) I = Ir () r = r XN( ε ) = S+ T G I XN = S + T G I() r XN( ε ) = S + T G I For a given domestic output (Y) and world interest rate (r), the equilibrium between excess domestic savings and net exports determines the equilibrium real interest rate (ε) Excess domestic savings do not depend on the real exchange rate. S+(T-G)-I may be considered as the net supply of domestic funds (and currency) in the international financial market. Net exports depend on the real exchange rate. XN may be considered as the net demand of domestic currency in the international financial market. ε represents the equilibrium real exchange rate 19 20
Equilibrium real interest rate Domestic fiscal policy. Increase in public spending (G 2 >G 1 ) (or tax cut (T 2 <T 1 )) An increase of G reduces national savings and the supply of domestic currency in foreign markets. The domestic currency becomes more expensive. Both the nominal and the real exchange rate appreciate. Net exports fall. Public deficits and trade deficits NOTE: Unlike what happens in the closed economy, now the reduction in public savings does not imply a reduction in domestic investment, since the country can always borrow in the international capital market. But to be able to do so, it must be prepared to run a trade deficit (or to reduce the trade surplus). Net exports must worsen and the economy loses competitiveness in the goods markets. Thus fiscal deficits undermine the countries position either by reducing investment and installed capacity (in the closed economy) or by worsening the competitive position of domestic firms selling abroad (in the open economy case). 21 22
The twin deficits in the U.S. Equilibrium real interest rate Percent of GDP 4 3 2 1 Public deficit (d) 8 Percent of GDP 6 4 2 Improvements in domestic expectations that raise investment (I 2 > I 1 ) Domestic demand rises, excess savings fall. The foreign supply of domestic currency falls. 0 0-1 -2-3 Net Exports (NE) -4 1950 1960 1970 1980 1990 2000-2 -4-6 -8 The domestic currency becomes more expensive. The exchange rate appreciates. Net exports fall. 23 24
The nominal exchange rate in the long run The real exchange rate only depends on real factors, over the long run. In fact, we have been able to determine its value without taking into account the quantity of money at home and abroad. XN( ε ) = S( Y T) + T G I( r) ( YTGr ) ε = ε,,, However, money supply affects the nominal exchange rate. The nominal exchange rate in the long run For a given value of the real exchange rate (ε, given by the real factors discussed before), the nominal exchange rate (e) may be written as follows: (,, ) P e = Y Y r P ε But, as we discussed previously (Topic 3) the price level in each economy is proportional to the money supply. Money market equilibrium, at home and abroad, mean: M LY (, r ) P = P = LY r M (, ) P M L( Y, r) = P M LY (, r ) 25 26
The nominal exchange rate in the long run In the long run changes in monetary polices at home (M) and abroad (M) do not have any real effect and only affect the nominal exchange rate (e). M L( Y, r) = ε (,, M M LY r ) e= h( Y, Y, r ) e Y Y r (, ) This can also be expressed in rates of change Differences in the rate of growth of money drive the rate of change of the Nominal exchange rate in the long run M e ε P P ε = + = + π π e ε P P ε e M M = e M M What have we learned? We study an small open economy in the long run: all prices are flexible (the supply curve is vertical). We look at the determination of savings and investment in the open economy. There is a new relative price to be considered: the exchange rate. The nominal exchange rate is the relative price of the currency in two countries. For instance, the euro/dollar nominal exchange rate tells us how many dollars we must pay to buy one euro or how many euros we are given for one dollar. Domestic investment can be financed by raising funds from public domestic savings, private savings as well as from foreign savings. 27 28
What have we learned? The real exchange rate depends only on real factors, over the long run. In fact, we have been able to determine its value without taking into account the quantity of money at home and abroad. For a given domestic output and world interest rate, the equilibrium between excess domestic savings and net exports determines the equilibrium real interest rate. In the long run, changes in monetary polices at home and abroad do not have any real effect and only affect the nominal exchange rate. 29