The classical model of the SMALL OPEN economy Open Economy Macroeconomics Dr hab. Joanna Siwińska-Gorzelak
Overview This lecture is based on the chapter The Open Economy from G. Mankiw Macroeconomics This lecture reviews accounting identities for the open economy the small open economy model what makes it small how the trade balance and exchange rate are determined how policies affect trade balance & exchange rate
Why learn this? To understand: what trade surpluses and trade deficits are. the link between the trade balance and net capital outflow or net lending to/borrowing from abroad why countries have huge trade deficits? what can the government do about this?
In an open economy, spending need not equal output saving need not equal investment
Preliminaries: spending in open economy d f C C C d f I I I d f G G G EX = exports = foreign spending on domestic goods IM = imports = C f + I f + G f = spending on foreign goods NX = net exports (a.k.a. the trade balance ) = EX IM superscripts: d = spending on domestic goods f = spending on foreign goods
The national income identity in an open economy d d d Y C I G EX ( C C f ) ( I I f ) ( G G f ) EX f f f C I G EX ( C I G ) C I G EX IM C I G NX
The national income identity in an open economy Y = C + I + G + NX or, NX = Y (C + I + G ) net exports domestic spending output
Trade surpluses and deficits NX = EX IM = Y (C + I + G ) trade surplus: output > spending and exports > imports Size of the trade surplus = NX trade deficit: spending > output and imports > exports Size of the trade deficit = NX
International capital flows Net capital outflow = S I = net (out)flow of loanable funds = net purchases of foreign assets the country s purchases of foreign assets minus foreign purchases of domestic assets When S > I, country is a net lender (funds flow out) When S < I, country is a net borrower (funds flow in)
The link between trade & cap. flows NX = Y (C + I + G ) implies NX = (Y C G ) I = S I trade balance = net capital outflow Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ).
Classical model of small open economy An open-economy version of the classical model of the closed economy: Includes many of the same elements: production function consumption function investment function exogenous policy variables Y Y F ( K, L) C C ( Y T ) I I ( r ) G G, T T assume fully flexible prices (!)
Classical model of SOP Assumptions: fully flexible prices; production always equal to potential output, economy is small, capital is perfectly mobile across countries This is a long run model (!), not suitable to analyse short-term shocks and fluctuations But it is also NOT a very long run growth model
National saving: The supply of loanable funds r S Y C ( Y T ) G Assumption made here: national saving does not depend on the interest rate S S, I
Recall: types of saving private saving = (Y T ) C public saving = T G national saving, S = private saving + public saving = (Y T ) C + T G = Y C G
Investment Recall from your macro course: Profit max. implies MPK = user cost User cost in its simplest form is: uc=(r+d) Hence, ceteris paribus, as r falls, the DESIRED level of capital stock increases, hence investment increases
Investment: The demand for loanable funds r r * Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate is one of the several factors that determines the I (r ) country s level of investment. I (r* ) S, I
If the economy were closed the interest rate would adjust to equate investment and saving: r r c S I (r ) I ( r ) S c S, I
Assumptions: Capital flows a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.); b. perfect capital mobility: no restrictions on international trade in assets c. economy is small: cannot affect the world interest rate, denoted r* a & b imply r = r* c implies r* is exogenous
But in a small open economy the exogenous world interest rate determines investment and the difference between saving and investment determines net capital (out)flow and net exports r* r r c I 1 NX S I (r ) S, I
A small open economy that lends abroad, with saving dependent on the interest rate
A small open economy that borrows from abroad, with saving that depends on the interest rate
Saving and Investment in a Small Open Economy Result: r w may be such that S d > I d, S d = I d, or S d < I d If S d > I d, the excess of desired saving over desired investment is lent internationally (net foreign lending is positive) and NX > 0 If S d = I d, there is no net foreign lending and NX = 0 If S d < I d, the excess of desired investment over desired saving is financed by borrowing internationally (net foreign lending is negative) and NX < 0
Next, three experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand
1. Fiscal policy at home r An increase in G or decrease in T reduces saving. * r1 NX 2 S 2 S 1 Results: NX 1 I 0 NX S 0 I (r ) I 1 S, I
1. Fiscal policy at home Recall that national saving is a sum of government saving and private saving The previous slide assumed that the change in fiscal policy will not affect private savings However, recall Ricardian Equivalence that holds that a change in public saving will be offset by the change in private saving
The Ricardian view due to David Ricardo (1820), more recently advanced by Robert Barro According to Ricardian equivalence, a debt-financed tax cut has no effect on consumption, national saving, net exports, or real GDP, even in the short run.
The logic of Ricardian Equivalence Consumers are forward-looking, know that a debt-financed tax cut today implies an increase in future taxes that is equal in present value to the tax cut. The tax cut does not make consumers better off, so they do not increase consumption spending. Instead, they save the full tax cut in order to repay the future tax liability. Result: Private saving rises by the amount public saving falls, leaving national saving unchanged.
2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. 1 r r * r2 * NX 2 NX 1 S 1 Results: I 0 NX I 0 I ( r ) * 2 I ( r ) * 1 I (r ) S, I
3. An increase in investment demand r S * r EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. I 1 NX 1 I (r ) 1 S, I
3. An increase in investment demand ANSWERS: I > 0, S = 0, net capital outflow and NX fall by the amount I r * r NX 1 NX 2 S I (r ) 1 I (r ) 2 I 1 I 2 S, I
The nominal exchange rate e = nominal exchange rate, the relative price of foreign currency in terms of domestic currency OR domestic currency in terms of foreign currency
The real exchange rate The real exchange rate is the price level adjusted exchange rate. Its meant to capture the relative value of goods and services across countries RER e P P * Foreign price Nominal Exchange Rate (DOMESTIC currency to FOREIGN currency) Domestic price
~ McZample ~ one good: Big Mac price in PL: P = 10 PLN price in USA: P* = $4.00 nominal exchange rate e = 4 PLN/$ ep* P 4 PLN *4USD USD 10PLN 16PLN 10PLN 1,6 To buy a U.S. Big Mac, someone from PL would have to pay an amount that could buy 1.6 Polish Big Mac. slide 32
ε in the real world & our model In the real world: We can think of ε as the relative price of a basket of domestic goods in terms of a basket of foreign goods In our macro model: There s just one good, output. So ε is the relative price of one country s output in terms of the other country s output
How NX depends on ε ε Home goods become LESS expensive relative to foreign goods IM, EX NX INCREASES
The net exports function The net exports function reflects this positive relationship between NX and ε : NX = NX(ε )
The NX curve for Home. When ε is relatively high, Home goods are relatively inexpensive ε so Home net exports will be high NX (ε) ε 1 0 NX(ε NX 1 )
How ε is determined The accounting identity says NX = S I We saw earlier how S I is determined: S depends on domestic factors (output, fiscal policy variables, etc) I is determined by the world interest rate r * So, ε must adjust to ensure NX ( ε ) S I ( r *)
How ε is determined Neither S nor I depend on ε, so the net capital outflow curve is vertical. ε adjusts to equate NX with net capital outflow, S I. ε ε 1 S1 I ( r *) NX 1 NX(ε ) NX
Interpretation: Supply and demand in the foreign exchange market Demand (NX): Demand for home currency to buy home s net exports. ε S1 I ( r *) Supply: Net capital flow (S I ) is the supply of home currency offered to buy Foreign s assets. ε 1 NX 1 NX(ε ) NX
Next, four experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports
1. Fiscal policy at home A fiscal expansion reduces national saving, decreases net capital outflow, and the supply of home currency in the foreign exchange market ε ε 1 ε 2 S 2 I( r*) S1 I ( r *) NX(ε ) causing the real exchange rate to appreciate and NX to decline (i.e. trade DEFICT to increase) NX 2 NX 1 NX
2. Fiscal policy abroad An increase in r* reduces investment, increasing net capital outflow and the supply of home currency in the foreign exchange market ε ε 2 ε 1 S I ( r *) 1 1 S 1 I( r2* ) NX(ε ) causing the real exchange rate to depreciate and NX to rise. NX 1 NX 2 NX
3. Increase in investment demand An increase in investment demand decreases net capital outflow and the supply of home currency in the foreign exchange market ε ε 1 ε 2 S1 I 2 S I 1 1 NX(ε ) causing the real exchange rate to appreciate and NX to fall. NX 2 NX 1 NX
4. Trade policy to restrict imports At any given value of ε, an import quota IM NX ε S I NX (ε ) 1 increases the (net) demand for home currency ε 1 ε 2 NX (ε ) 2 Trade policy doesn t affect S or I, so capital flows and the (S-I) or supply of currency remains fixed. NX 1 NX
4. Trade policy to restrict imports Results: ε < 0 (demand increase) NX = 0 (supply fixed) IM < 0 (policy) ε ε 1 ε 2 S I NX (ε ) 1 NX (ε ) 2 EX < 0 (decrease in ε ) NX 1 NX
The determinants of the nominal exchange rate - intro Start with the expression for the real exchange rate: Solve for the nominal exchange rate: P P e * e P P *
The determinants of the nominal exchange rate - intro So e depends on the real exchange rate and the price levels at home and abroad and we know how each M L r of them is determined: P ( *, Y ) e P P * NX ( ε ) S I ( r *) M P * * * L ( r * *, Y ) *
Implications for growth Recall the Solow growth model, where the setady state level of capital per labour depends on the amount of savings This no longer holds, as the level of investment at least in theory is detached from savings The steady-state value of capital stock should depend on world interest rate and on country s marginal product of capital The Open Economy
Chapter Summary Net exports--the difference between exports and imports a country s output (Y ) and its spending (C + I + G) Net capital outflow equals purchases of foreign assets minus foreign purchases of the country s assets the difference between saving and investment slide 49
Chapter Summary National income accounts identities: Y = C + I + G + NX trade balance NX = S I net capital outflow Impact of policies on NX : NX increases if policy causes S to rise or I to fall NX does not change if policy affects neither S nor I. Example: trade policy slide 50
Chapter Summary Exchange rates nominal: the price of a country s currency in terms of another country s currency real: the price of a country s goods in terms of another country s goods The real exchange rate equals the nominal rate times the ratio of prices of the two countries. slide 51
Chapter Summary How the real exchange rate is determined NX depends negatively on the real exchange rate, other things equal The real exchange rate adjusts to equate NX with net capital outflow slide 52