Sherif Khalifa Sherif Khalifa () Open Economy 1 / 70
Definition A closed economy is an economy that does not interact with other economies. Definition An open economy is an economy that interacts freely with other economies. Sherif Khalifa () Open Economy 2 / 70
Definition Exports are goods and services that are produced domestically and sold abroad. Definition Imports are goods and services that are produced abroad and sold domestically. Definition Net exports is the value of a nation s exports minus the value of its imports. Net exports is also called the trade balance. Net exports = Value of country s exports Value of country s imports Sherif Khalifa () Open Economy 3 / 70
If net exports are positive, exports are larger than imports, and the country is said to run a trade surplus. If net exports are negative, imports are larger than exports, and the country is said to run a trade deficit. If net exports are zero, imports equal exports, and the country is said to have a balanced trade. Sherif Khalifa () Open Economy 4 / 70
Factors that influence net exports: The tastes of consumers for domestic and foreign goods. The prices of domestic and foreign goods. The incomes of consumers at home and abroad. The exchange rates between domestic currency and foreign currencies. The cost of transporting goods from country to country. Government policies toward international trade. Sherif Khalifa () Open Economy 5 / 70
Definition Net capital outflow is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Net capital outflow = Capital outflow Capital inflow = Purchase of foreign assets by domestic residents Purchase of domestic assets by foreigners When NCO > 0, domestic purchases of foreign assets > foreign purchases of domestic assets. When NCO < 0, foreign purchases of domestic assets > domestic purchases of foreign assets. Sherif Khalifa () Open Economy 6 / 70
Factors that influence net capital outflow: The real interest rate paid on foreign assets. The real interest rate paid on domestic assets. The perceived economic and political risks of holding assets abroad. The government policies that affect foreign ownership of domestic assets. Sherif Khalifa () Open Economy 7 / 70
NCO = NX When a foreigner purchases a good from the United States, American exports and net exports increase. The foreigner pays with currency or assets. The United States acquires some foreign assets, causing net capital outlfow to increase. When an American citizen buys foreign goods, American imports increase and net exports decrease. The American buyer pays with United States dollars or assets. The other country acquires American assets, causing American net capital outflow to decrease. Sherif Khalifa () Open Economy 8 / 70
Y = C d + I d + G d + X C = C d + C f I = I d + I f G = G d + G f ( ) ( ) ( ) Y = C C f + I I f + G G f + X Y = C + I + G + X (C ) f + I f + G f Y = C + I + G + X M Y = C + I + G + NX Sherif Khalifa () Open Economy 9 / 70
Y = C + I + G + NX Y C G = I + NX S = I + NX S I = NX S I = NCO Net Capital Outflow = Trade Balance Sherif Khalifa () Open Economy 10 / 70
If net capital outflow is positive, saving exceeds investment and the economy is lending the excess to foreigners. If net capital outflow is negative, investment exceeds saving and the economy is financing this by borrowing from foreigners. If domestic saving exceeds domestic investment, the surplus saving is used to make loans to foreigners. Foreigners require these loans because we are providing them with more goods and services than they are providing us. If domestic investment exceeds domestic saving, the extra investment must be financed by borrowing from abroad. These foreign loans enable us to import more goods and services than we export to foreigners. Sherif Khalifa () Open Economy 11 / 70
Percent of GDP 15% 10% 5% Exports Imports 0% 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Sherif Khalifa () Open Economy 12 / 70
Saving, Investment (% of GDP) 20% 16% 12% 8% 4% NCO (right scale) Investment Saving 10% 8% 6% 4% 2% 0% 2% 4% 6% Net Capital Outflow (% of GDP) 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Sherif Khalifa () Open Economy 13 / 70
Exchange Rates Sherif Khalifa () Open Economy 14 / 70
Exchange Rates Definition The exchange rate between two countries is the price at which residents of those countries trade with each other. Definition The nominal exchange rate is the relative price of the currencies of two countries. When the domestic currency appreciates, it buys more of the foreign currency; when it depreciates, it buys less. Definition The real exchange rate is the relative price of the goods of two countries. It is the rate at which we can trade the goods of one country for the goods of another Sherif Khalifa () Open Economy 15 / 70
Exchange Rates Real Exchange Rate = Nominal Exchange Rate ( ) Domestic Price Foreign Price Sherif Khalifa () Open Economy 16 / 70
Exchange Rates ( ) P ɛ = e P ( P ) e = ɛ P % e = % ɛ + % P % P = % ɛ + π π If a country has a high inflation rate relative to the United States, a dollar will buy an increasing amount of the foreign currency over time. If a country has a low inflation rate relative to the United States, a dollar will buy a decreasing amount of the foreign currency over time. Sherif Khalifa () Open Economy 17 / 70
Exchange Rates Example Assume the price of an American car=$10,000, and the price of a Japanese car=2,400,000 Yen. $1 = 120yen Real Exchange Rate = 1 American car = 1 2 120x10, 000 2, 400, 000 = 1 2 Japanese car Sherif Khalifa () Open Economy 18 / 70
Exchange Rates Example Assume the price of and American television=$100, and the price of a Japanese television= 16,000 Yen. $1 = 80Yen. Real exchange rate = 1 American television = 1 2 80x 100 16000 = 1 2 Japanese television Sherif Khalifa () Open Economy 19 / 70
Exchange Rates Example Assume that 4/5 pounds of Japanese beef = 1 pound of U.S. beef. The price of a pound of U.S. beef = $2 $1 = 600Yen Real exchange rate = ( ) 4 5 = Canadian price = 1200x5 4 Nominal exchange rate x Domestic price Foreign price 600x2 Canadian price = 1500 Sherif Khalifa () Open Economy 20 / 70
Exchange Rates Definition The law of one price states that the same good cannot sell for different prices in different locations at the same time. Definition Purchasing power parity states that, if international arbitrage is possible, a dollar must have the same purchasing power in every country. Sherif Khalifa () Open Economy 21 / 70
Exchange Rates If a dollar could buy more of a good domestically than abroad, there would be opportunities to profit by buying this good domestically and selling it abroad. Profit seeking arbitrageurs would drive up the domestic price of the good relative to the foreign price. If a dollar could buy more of a good abroad than domestically, there would be opportunities to profit by buying this good abroad and selling it domestically. Profit seeking arbitrageurs would drive down the domestic price of the good relative to the foreign price. This process of arbitrage will lead eventually to the equalization of the domestic and foreign prices. Sherif Khalifa () Open Economy 22 / 70
Exchange Rates Example Assume purchasing power parity holds. The price of coffee in Japan = 500 Yen, and the price of coffee in the United States = $5. Nominal Exchange rate = 500Yen $5 Real Exchange rate = 1 = 100Yen $1 Sherif Khalifa () Open Economy 23 / 70
Exchange Rates Definition The Big Mac index is an index compiled by The Economist, that collects data on the price of McDonald s Big Mac burger that is sold in different countries. In the Big Mac index, the basket is considered to be a single Big Mac as sold by the McDonald s fast food chain. The Big Mac index is the cost of a Big Mac in one country (in its currency) divided by the cost of a Big Mac in another country (in its currency). The Big Mac index is then compared with the actual exchange rate. If it is lower, then the first currency is under-valued compared to the second. If it is higher, then the first currency is over-valued compraed to the second. Sherif Khalifa () Open Economy 24 / 70
Exchange Rates If the exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. Domestic residents will want to buy many imported goods, and foreigners will want to buy few of our goods. Therefore, the quantity of our net exports demanded will be low. If the exchange rate is low, foreign goods are relatively expensive, and domestic goods are relatively cheap. Domestic residents will want to purchase fewer imported goods, and foreigners will want to buy more of our goods. Therefore, the quantity of our net exports demanded will be high. Sherif Khalifa () Open Economy 25 / 70
Open Economy Model S = I + NCO Supply of loanable funds comes from public savings and private savings. Demand for loanable funds comes from domestic investment and net capital outflow. A higher interest rate encourages people to save and increases the quantity of loanable funds supplied. A higher interest rate makes borrowing costly, discourages investment and decreases the quantity of loanable funds demanded. A higher interest rate discourages Americans from buying foreign assets and encourages foreigners to buy American assets, and thus decreases net capital outflow. At the equilibrium interest rate, the amount that people want to save exactly balances domestic investment and net capital outflow. Sherif Khalifa () Open Economy 26 / 70
Open Economy Model r S(S) r 1 D(I+NCO) L 1 L Sherif Khalifa () Open Economy 27 / 70
Open Economy Model NCO = NX NX determines the demand for dollars, because foreigners need and demand dollars to buy American net exports. NCO is the supply of dollars, because Americans sell dollars to obtain the foreign currency they need to buy foreign assets. A higher real exchange rate makes American products more expensive and lowers the quantity of dollars demanded to buy those goods. The supply curve is vertical because the quantity of dollars supplied for net capital outflow does not depend on the exchange rate. At the equilibrium exchange rate, the demand for dollars by foreigners for U.S. net exports exactly balances the supply of dollars from Americans from U.S. net capital outflow. Sherif Khalifa () Open Economy 28 / 70
Open Economy Model e S(NCO) e 1 D(NX) Q 1 $ Sherif Khalifa () Open Economy 29 / 70
Open Economy Model r NCO NCO Sherif Khalifa () Open Economy 30 / 70
Open Economy Model r S(S) r r 1 D(I+NCO) NCO L 1 L e S(NCO) NCO e 1 D(NX) $ Sherif Khalifa () Open Economy 31 / 70
A budget deficit decreases the supply of loanable funds and increases the interest rate. With a higher interest rate, net capital outflow decreases because investing abroad is less attractive. Higher rates of return also attract foreign investors who want to earn the higher returns on American assets. People need less foreign currency to buy foreign assets, and therefore supply fewer dollars in the market. The decreased supply of dollars causes the exchange rate to appreciate in value. This makes American products more expensive decreasing U.S. exports and causing a trade deficit. Sherif Khalifa () Open Economy 32 / 70 Open Economy Open Economy Model Definition A budget deficit occurs when the government spends more than it collects in taxes.
Open Economy Model r S(S) r r 2 r 1 D(I+NCO) NCO L 1 L e S(NCO) NCO e 2 e 1 D(NX) $ Sherif Khalifa () Open Economy 33 / 70
Open Economy Model The Twin Deficits Net exports and the budget deficit often move in opposite directions. Percent of GDP 5% 4% 3% 2% 1% 0% 1% 2% 3% 4% 5% 1961 65 U.S. federal budget deficit 1966 70 U.S. net exports 1971 75 1976 80 1981 85 1986 90 1991 95 1995 2000 2001 05 Sherif Khalifa () Open Economy 34 / 70
Open Economy Model Definition An import tariff is a tax on imported foreign products, and is a form of trade barriers. A trade import tariff decreases imports at any given exchange rate, and thus increases net exports. Foreigners need dollars to buy American net exports, and the demand for dollars increases. The increase in the demand for dollars causes the dollar to appreciate versus the foreign currency. This causes domestic products to become more expensive compared to foreign products. This encourages imports and discourages exports which work to offset the increase in net exports due to the import tariff. Sherif Khalifa () Open Economy 35 / 70
Open Economy Model r S(S) r r 1 D(I+NCO) NCO L 1 L e S(NCO) NCO e 2 e 1 D(NX) $ Sherif Khalifa () Open Economy 36 / 70
Open Economy Model Definition Capital flight is a large and sudden decrease in the demand for assets located in a country. Investors sell their Mexican assets and buy American assets, which increases Mexican net capital outflow. There is greater demand for loanable funds to finance these purchases of capital assets abroad. This causes the equilibrium interest rate in Mexico to increase. The increase in net capital outflow increases the supply of Pesos, which causes the Peso to depreciate. This makes exports cheaper and imports more expensive, pushing the trade balance into surplus. Sherif Khalifa () Open Economy 37 / 70
Open Economy Model r S(S) r r 2 r 1 D(I+NCO) NCO L 1 L e S(NCO) NCO e 1 e 2 D(NX) $ Sherif Khalifa () Open Economy 38 / 70
The market for loanable funds can be replaced by the IS/LM model. This allows for the analysis of the effects of policy changes on the exchange rate. Changes in fiscal policy by the government cause a shift in the IS curve. Changes in monetary policy by the central bank cause a shift in the LM curve. Sherif Khalifa () Open Economy 39 / 70
r LM r r 1 IS NCO Y 1 Y e S(NCO) NCO e 1 D(NX) $ Sherif Khalifa () Open Economy 40 / 70
Definition An expansionary fiscal policy includes either an increase in government spending or a decrease in taxes. An increase in government purchases or a cut in taxes shifts the IS curve to the right. This shift leads to an increase in income and an increase in the interest rate. The higher equilibrium interest rate decreases the net capital outflow. This decreases the supply of dollars and the exchange rate appreciates. Domestic goods become more expensive relative to foreign goods, and net exports fall. Sherif Khalifa () Open Economy 41 / 70
r LM r r 2 r 1 IS NCO Y 1 Y e S(NCO) NCO e 2 e 1 D(NX) $ Sherif Khalifa () Open Economy 42 / 70
Definition An expansionary monetary policy includes either an increase in money supply or a decrease in interest rates. An increase in the money supply shifts the LM curve to the right. The level of income increases and the interest rate decreases. The lower equilibrium interest rate leads to a higher net capital outflow. This increases the supply of dollars and the exchange rate decreases. Domestic goods become cheaper relative to foreign goods, and net exports increase. Sherif Khalifa () Open Economy 43 / 70
r LM r r 1 r 2 IS NCO Y 1 Y e S(NCO) NCO e 1 e 2 D(NX) $ Sherif Khalifa () Open Economy 44 / 70
Definition A small open economy is an economy that is a small part of the world market and thus can have only a negligible effect on the world interest rate. Definition Perfect capital mobility means the residents of the country have full access to world financial world markets. Sherif Khalifa () Open Economy 45 / 70
r = r Residents of the small open economy need never borrow at any interest rate above r, because they can always get a loan at r from abroad. Residents of the small open economy need never lend at any interest rate below r, because they can always earn r by lending abroad. If the domestic interest rate increases, foreigners would see the high rate and start lending to this country The capital inflow would drive the domestic interest rate back down to r. If the domestic interest rate decreases, capital would flow out of the country to earn a higher return abroad. The capital outflow would drive the domestic interest rate back up to r. Sherif Khalifa () Open Economy 46 / 70
Y = Y = F ( K, L ) C = C (Y T ) I = I (r ) (Y C G ) I = NX [ Y C ( Y T ) G ] I (r ) = NX Y = C + I + G + NX S I (r ) = NX Sherif Khalifa () Open Economy 47 / 70
r S r 1 I(r) I,S Sherif Khalifa () Open Economy 48 / 70
Fiscal Expansion at Home The increase in domestic government spending decreases national saving. With an unchanged world real interest rate, investment remains the same. Saving falls below investment, and some investment must be financed by borrowing from abroad. The fall in saving implies a fall in net exports, and the economy runs a trade deficit. Sherif Khalifa () Open Economy 49 / 70
Fiscal Expansion at Home r S r 1 NX I(r) I,S Sherif Khalifa () Open Economy 50 / 70
Fiscal Expansion Abroad The increase in government spending abroad decreases world saving. The decrease in world saving causes the world interest rate to increase. The increase in the world interest rate decreases investment. Saving now exceeds investment, and saving begins to flow abroad. The decrease in investment also increase net exports and causes a trade surplus. Sherif Khalifa () Open Economy 51 / 70
Fiscal Expansion Abroad r S r 2 NX r 1 I(r) I,S Sherif Khalifa () Open Economy 52 / 70
Mundell-Fleming r = r Y = C (Y T ) + I (r ) + G + NX (e) Sherif Khalifa () Open Economy 53 / 70
Mundell-Fleming E AE PE 1 PE 2 e e Y 2 Y 1 Y e 2 e 2 e 1 e 1 NX(e) IS * NX 2 NX 1 NX Y 2 Y 1 Y Sherif Khalifa () Open Economy 54 / 70
Mundell-Fleming An increase in the exchange rate lowers net exports. This shifts the planned expenditure schedule downward and thus lowers income. The IS curve summarizes this relationship between the exchange rate and income. Sherif Khalifa () Open Economy 55 / 70
Mundell-Fleming E AE PE 2 PE 1 e e Y 1 Y 2 Y e 1 e 1 IS * 2 NX(e) IS * 1 NX 1 NX Y 1 Y 2 Y Sherif Khalifa () Open Economy 56 / 70
Mundell-Fleming M P = L (r, Y ) M P = L (r, Y ) The supply of real money balances equals the demand for real money balances. The demand for real money balances depends negatively on the interest rate and positively on income. The supply of real money balances is controlled by the central bank. Sherif Khalifa () Open Economy 57 / 70
Mundell-Fleming e LM * Y 1 Y Sherif Khalifa () Open Economy 58 / 70
Mundell-Fleming e LM * e 1 Y 1 IS * Y Sherif Khalifa () Open Economy 59 / 70
Mundell-Fleming Definition Under a system of floating exchange rates, the exchange rate is set by market forces and is allowed to fluctuate in response to changing economic conditions. Sherif Khalifa () Open Economy 60 / 70
Mundell-Fleming Expansionary fiscal policy increases planned expenditure, and shifts the IS curve to the right. The exchange rate appreciates, while the level of income remains the same. As the interest rate increases above the world interest rate, foreign investors buy the domestic currency to invest in the domestic economy. The capital inflow increases the demand for the domestic currency, bidding up the value of the domestic currency. The appreciation of the domestic currency makes domestic goods expensive relative to foreign goods, reducing net exports. The fall in net exports exactly offsets the effects of the expansionary fiscal policy on income. Sherif Khalifa () Open Economy 61 / 70
Mundell-Fleming e LM * 1 e 2 e 1 IS * 2 Y 1 IS * 1 Y Sherif Khalifa () Open Economy 62 / 70
Mundell-Fleming Suppose the central bank conducts an expansionary policy by increasing the money supply. The increase in real money balances shifts the LM curve to the right. An increase in the money supply increases income and lowers the exchange rate. As the increase in money supply starts to put downward pressure on the domestic interest rate. Capital flows out of the economy as investors seek a higher return elsewhere. Sherif Khalifa () Open Economy 63 / 70
Mundell-Fleming The capital outflow prevents the domestic interest rate from falling below the world interest rate. Investing abroad requires converting domestic currency into foreign currency. The capital outflow increases the supply of domestic currency. This causes the domestic currency to depreciate in value. This makes domestic goods inexpensive relative to foreign goods. This stimulates net exports and thus total income. Sherif Khalifa () Open Economy 64 / 70
Mundell-Fleming e LM * 1 LM * 2 e 1 e 2 Y 1 Y 2 IS * 1 Y Sherif Khalifa () Open Economy 65 / 70
Mundell-Fleming Definition Under a fixed exchange rate, the central bank announces a value for the exchange rate and stands to buy and sell the domestic currency to keep the exchange rate at its announced level. Sherif Khalifa () Open Economy 66 / 70
Mundell-Fleming Expansionary fiscal policy increases planned expenditure, and shifts the IS curve to the right. This puts upward pressure on the market exchange rate. Arbitrageurs respond to the rising exchange rate by selling foreign currency to the central bank. This leads to a monetary expansion which shifts the LM curve to the right. Sherif Khalifa () Open Economy 67 / 70
Mundell-Fleming e LM * 1 LM * 2 e 2 e 1 IS * 2 Y 1 Y 2 IS * 1 Y Sherif Khalifa () Open Economy 68 / 70
Mundell-Fleming Suppose the central bank conducts expansionary policy by increasing the money supply. The increase in real money balances shifts the LM curve to the right. An increase in the money supply increases income and lowers the exchange rate. Arbitrageurs respond to the falling exchange rate by selling the domestic currency to the central bank. This causes the money supply and the LM curve to return to their initial positions. Sherif Khalifa () Open Economy 69 / 70
Mundell-Fleming e LM * 1 LM * 2 e 1 e 2 Y 1 Y 2 IS * 1 Y Sherif Khalifa () Open Economy 70 / 70