Closed vs. Open Economies

Closed vs. Open Economies! A closed economy does not interact with other economies in the world.! An open economy interacts freely with other economies around the world. 1

Percent of GDP The U.S. Economy s Increasing Openness 20% 18% 16% 14% 12% Imports 10% 8% Exports 6% 4% 2% 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2

The Flow of Goods & Services! Exports: domestically-produced g&s sold abroad! Imports: foreign-produced g&s sold domestically! Net exports (NX), aka the trade balance = value of exports value of imports 3

ACTIVE LEARNING 1 Variables that affect NX What do you think would happen to U.S. net exports if: A. Canada experiences a recession (falling incomes, rising unemployment) B. U.S. consumers decide to be patriotic and buy more products Made in the U.S.A. C. Prices of goods produced in Mexico rise faster than prices of goods produced in the U.S.

Trade Surpluses & Deficits NX measures the imbalance in a country s trade in goods and services.! Trade deficit: an excess of imports over exports! Trade surplus: an excess of exports over imports! Balanced trade: when exports = imports 5

The Flow of Capital! Net capital outflow (NCO): domestic residents purchases of foreign assets minus foreigners purchases of domestic assets! NCO is also called net foreign investment. 6

The Flow of Capital The flow of capital abroad takes two forms:! Foreign direct investment: Domestic residents actively manage the foreign investment, e.g., McDonalds opens a fast-food outlet in Moscow.! Foreign portfolio investment: Domestic residents purchase foreign stocks or bonds, supplying loanable funds to a foreign firm. 7

The Flow of Capital NCO measures the imbalance in a country s trade in assets:! When NCO > 0, capital outflow Domestic purchases of foreign assets exceed foreign purchases of domestic assets.! When NCO < 0, capital inflow Foreign purchases of domestic assets exceed domestic purchases of foreign assets. 8

Variables that Influence NCO! Real interest rates paid on foreign assets! Real interest rates paid on domestic assets! Perceived risks of holding foreign assets! Govt policies affecting foreign ownership of domestic assets 9

The Equality of NX and NCO! An accounting identity: NCO = NX! arises because every transaction that affects NX also affects NCO by the same amount (and vice versa)! When a foreigner purchases a good from the U.S.,! U.S. exports and NX increase! the foreigner pays with currency or assets, so the U.S. acquires some foreign assets, causing NCO to rise. 10

The Equality of NX and NCO! An accounting identity: NCO = NX! arises because every transaction that affects NX also affects NCO by the same amount (and vice versa)! When a U.S. citizen buys foreign goods,! U.S. imports rise, NX falls! the U.S. buyer pays with U.S. dollars or assets, so the other country acquires U.S. assets, causing U.S. NCO to fall. 11

Saving, Investment, and International Flows of Goods & Assets Y = C + I + G + NX accounting identity Y C G = I + NX rearranging terms S = I + NX since S = Y C G S = I + NCO since NX = NCO! When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow.! When S < I, foreigners are financing some of the country s investment, and NCO < 0. 12

Case Study: The U.S. Trade Deficit! The U.S. trade deficit reached record levels in 2006 and remained high in 2007 2008.! Recall, NX = S I = NCO. A trade deficit means I > S, so the nation borrows the difference from foreigners.! In 2007, foreign purchases of U.S. assets exceeded U.S. purchases of foreign assets by $775 million.! Such deficits have been the norm since 1980 13

U.S. Saving, Investment, and NCO, 1950 2012 24% 21% 18% Investment (% of GDP) 15% 12% 9% 6% Saving 3% 0% NCO -3% -6% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Case Study: The U.S. Trade Deficit Why U.S. saving has been less than investment:! In the 1980s and early 2000s, huge govt budget deficits and low private saving depressed national saving.! In the 1990s, national saving increased as the economy grew, but domestic investment increased even faster due to the information technology boom. 15

Case Study: The U.S. Trade Deficit! Is the U.S. trade deficit a problem?! The extra capital stock from the 90s investment boom may well yield large returns.! The fall in saving of the 80s and 00s, while not desirable, at least did not depress domestic investment, since firms could borrow from abroad.! A country, like a person, can go into debt for good reasons or bad ones. A trade deficit is not necessarily a problem, but might be a symptom of a problem. 16

The Nominal Exchange Rate! Nominal exchange rate: the rate at which one country s currency trades for another! We express all exchange rates as foreign currency per unit of domestic currency.! Some exchange rates as of 29 January 2014, all per US$ Canadian dollar: 1.12 Euro: 0.73 Japanese yen: 102.34 Mexican peso: 13.41 17

Appreciation and Depreciation! Appreciation (or strengthening ): an increase in the value of a currency as measured by the amount of foreign currency it can buy! Depreciation (or weakening ): a decrease in the value of a currency as measured by the amount of foreign currency it can buy! Examples: During 2007, the U.S. dollar! depreciated 9.5% against the Euro! appreciated 1.5% against the S. Korean Won 18

The Real Exchange Rate! Real exchange rate: the rate at which the g&s of one country trade for the g&s of another e x P! Real exchange rate = P* where P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate, i.e., foreign currency per unit of domestic currency 19

Example With One Good! A Big Mac costs $2.50 in U.S., 400 yen in Japan! e = 120 yen per $! e x P = price in yen of a U.S. Big Mac = (120 yen per $) x ($2.50 per Big Mac) = 300 yen per U.S. Big Mac! Compute the real exchange rate: e x P P* = 300 yen per U.S. Big Mac 400 yen per Japanese Big Mac = 0.75 Japanese Big Macs per U.S. Big Mac 20

Interpreting the Real Exchange Rate The real exchange rate = 0.75 Japanese Big Macs per U.S. Big Mac Correct interpretation: To buy a Big Mac in the U.S., a Japanese citizen must sacrifice an amount that could purchase 0.75 Big Macs in Japan. 21

ACTIVE LEARNING 2 Compute a real exchange rate e = 10 pesos per $ price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico A. What is the price of a U.S. latte measured in pesos? B. Calculate the real exchange rate, measured as Mexican lattes per U.S. latte.

The Real Exchange Rate With Many Goods P = U.S. price level, e.g., Consumer Price Index, measures the price of a basket of goods P* = foreign price level Real exchange rate = (e x P)/P* = price of a domestic basket of goods relative to price of a foreign basket of goods! If U.S. real exchange rate appreciates, U.S. goods become more expensive relative to foreign goods. 23

Theory of FX Exchange Rates: Long-Run! We now study a theory of FX rate determination in the Long-Run.! It s called Purchasing-power parity. 24

The Law of One Price! Law of one price: the notion that a good should sell for the same price in all markets! Suppose coffee sells for $4/pound in Seattle and $5/pound in Boston, and can be costlessly transported.! There is an opportunity for arbitrage, making a quick profit by buying coffee in Seattle and selling it in Boston.! Such arbitrage drives up the price in Seattle and drives down the price in Boston, until the two prices are equal. 25

Purchasing-Power Parity (PPP)! Purchasing-power parity: a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries! based on the law of one price! implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries 26

Purchasing-Power Parity (PPP)! Example: The basket contains a Big Mac. P = price of U.S. Big Mac (in dollars) P* = price of Japanese Big Mac (in yen) e = exchange rate, yen per dollar! According to PPP, e x P = P* price of U.S. Big Mac, in yen price of Japanese Big Mac, in yen! Solve for e: e = P* P 27

PPP and Its Implications! PPP implies that the nominal exchange rate between two countries should equal the ratio of price levels. e =! If the two countries have different inflation rates, then e will change over time:! If inflation is higher in Mexico than in the U.S., then P* rises faster than P, so e rises the dollar appreciates against the peso.! If inflation is higher in the U.S. than in Japan, then P rises faster than P*, so e falls the dollar depreciates against the yen. P* P 28

Limitations of PPP Theory Two reasons why exchange rates do not always adjust to equalize prices across countries:! Many goods cannot easily be traded.! Examples: haircuts, going to the movies! Price differences on such goods cannot be arbitraged away! Foreign, domestic goods not perfect substitutes.! E.g., some U.S. consumers prefer Toyotas over Chevys, or vice versa! Price differences reflect taste differences 29

Limitations of PPP Theory! Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends.! For example, PPP implies: the greater a country s inflation rate, the faster its currency should depreciate (relative to a low-inflation country like the US).! The data support this prediction 30

Inflation & Depreciation in a Cross-Section of 31 Countries Ukraine Avg annual depreciation relative to US dollar 1993 2003 (log scale) Romania Argentina Mexico Canada Kenya Japan Brazil Avg annual CPI inflation 1993 2003 (log scale)

ACTIVE LEARNING 3 Chapter review questions 1. Which of the following statements about a country with a trade deficit is not true? A. Exports < imports B. Net capital outflow < 0 C. Investment < saving D. Y < C + I + G 2. A Ford Escape SUV sells for $24,000 in the U.S. and 720,000 rubles in Russia. If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)?

Theory of FX Exchange Rates: Short-Run! We now study a theory of FX rate determination in the Short-Run.! One crucial assumption:! Price level in two countries are FIXED!! FX rates do NOT affect GDP! 33

The Market for Foreign-Currency Exchange! Another identity from the preceding chapter: Net capital outflow NCO = NX Net exports! In the market for foreign-currency exchange,! NX is the demand for dollars: Foreigners need dollars to buy U.S. net exports.! NCO is the supply of dollars: U.S. residents sell dollars to obtain the foreign currency they need to buy foreign assets. 34

The Market for Foreign-Currency Exchange! Recall: The U.S. real exchange rate (E) measures the quantity of foreign goods & services that trade for one unit of U.S. goods & services.! E is the real value of a dollar in the market for foreign-currency exchange. 35

The Market for Foreign-Currency Exchange E adjusts to balance supply and demand for dollars in the market for foreigncurrency exchange. E S = NCO An increase in E has no effect on saving or investment, so it does not affect NCO or the supply of dollars. E 1 D = NX Dollars 36

A Theory of the Open Economy! Now, we combine all these things together to come up with a theory of the open economy.! We will use this theory to see how govt policies and various events affect the trade balance, exchange rate, and capital flows.! We start with the loanable funds market 37

The Market for Loanable Funds! An identity from the preceding chapter: Saving S = I + NCO Domestic investment Net capital outflow! Supply of loanable funds = saving.! A dollar of saving can be used to finance:! the purchase of domestic capital! the purchase of a foreign asset! So, demand for loanable funds = I + NCO 38

The Market for Loanable Funds! Recall:! S depends positively on the real interest rate, r.! I depends negatively on r.! What about NCO? 39

How NCO Depends on the Real Interest Rate The real interest rate, r, is the real return on domestic assets. A fall in r makes domestic assets less attractive relative to foreign assets.! People in the U.S. purchase more foreign assets.! People abroad purchase fewer U.S. assets.! NCO rises. r 1 r 2 r Net capital outflow NCO NCO NCO 1 NCO 2 40

The Loanable Funds Market Diagram r 1 r Loanable funds S = saving D = I + NCO r adjusts to balance supply and demand in the LF market. Both I and NCO depend negatively on r, so the D curve is downward-sloping. LF 41

ACTIVE LEARNING 1 Budget deficits and capital flows! Suppose the government runs a budget deficit (previously, the budget was balanced).! Use the appropriate diagrams to determine the effects on the real interest rate and net capital outflow. 2015 Cengage 2015 Cengage Learning. Learning. All Rights All Reserved. Rights Reserved. May not May be copied, not be copied, scanned, scanned, or duplicated, or duplicated, in whole in or whole in part, or in except part, for except use as for use as permitted permitted in a license in a distributed license distributed with a certain with a product certain product or service or or service otherwise or otherwise on a on a password-protected website website for classroom for classroom use. use. 42

ACTIVE LEARNING 2 Budget deficit, exchange rate, NX! Initially, the government budget is balanced and trade is balanced (NX = 0).! Suppose the government runs a budget deficit. As we saw earlier, r rises and NCO falls.! How does the budget deficit affect the U.S. real exchange rate? The balance of trade? 2015 Cengage 2015 Cengage Learning. Learning. All Rights All Reserved. Rights Reserved. May not May be copied, not be copied, scanned, scanned, or duplicated, or duplicated, in whole in or whole in part, or in except part, for except use as for use as permitted permitted in a license in a distributed license distributed with a certain with a product certain product or service or or service otherwise or otherwise on a on a password-protected website website for classroom for classroom use. use. 43

The Twin Deficits Percent of GDP 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% U.S. federal budget deficit Net exports and the budget deficit often move in opposite directions. U.S. net exports 1961-65 1966-70 1971-75 1976-80 1981-85 1986-90 1991-95 1996-2000 2001-2005 2006-2010 44

The Connection Between Interest Rates and Exchange Rates r 2 r 1 r Anything Keep that in mind: The increases LF market r (not shown) will reduce determines NCO r. and the This supply value of r dollars then determines the foreign NCO exchange (shown in upper market. graph). This value of NCO then Result: determines supply of The real exchange dollars in foreign exchange rate appreciates. market (in lower graph). E 2 E 1 E NCO 2 S 2 NCO 2 NCO NCO NCO 1 S 1 = NCO 1 D = NX NCO 1 dollars 45

SUMMARY: The Effects of a Budget Deficit! National saving falls.! The real interest rate rises.! Domestic investment and net capital outflow both fall.! The real exchange rate appreciates.! Net exports fall (or, the trade deficit increases). 46

SUMMARY: The Effects of a Budget Deficit! One other effect: As foreigners acquire more domestic assets, the country s debt to the rest of the world increases.! Due to many years of budget and trade deficits, the U.S. is now the world s largest debtor nation. International Investment Position of the U.S. 31 October 2013 Value of U.S.-owned foreign assets $21.6 trillion Value of foreign-owned U.S. assets U.S. net debt to the rest of the world $25.8 trillion $ 4.2 trillion 47

ACTIVE LEARNING 3 Investment incentives! Suppose the government provides new tax incentives to encourage investment.! Use the appropriate diagrams to determine how this policy would affect:! the real interest rate! net capital outflow! the real exchange rate! net exports 2015 Cengage 2015 Cengage Learning. Learning. All Rights All Reserved. Rights Reserved. May not May be copied, not be copied, scanned, scanned, or duplicated, or duplicated, in whole in or whole in part, or in except part, for except use as for use as permitted permitted in a license in a distributed license distributed with a certain with a product certain product or service or or service otherwise or otherwise on a on a password-protected website website for classroom for classroom use. use. 48

Trade Policy! Trade policy: a govt policy that directly influences the quantity of g&s that a country imports or exports! Examples:! Tariff a tax on imports! Import quota a limit on the quantity of imports! Voluntary export restrictions the govt pressures another country to restrict its exports; essentially the same as an import quota 49

Trade Policy! Common reasons for policies that restrict imports:! Save jobs in a domestic industry that has difficulty competing with imports! Reduce the trade deficit! Do such trade policies accomplish these goals?! Let s use our model to analyze the effects of an import quota on cars from Japan designed to save jobs in the U.S. auto industry. 50

Analysis of a Quota on Cars from Japan An import quota does not affect saving or investment, so it does not affect NCO. (Recall: NCO = S I.) r Loanable funds r Net capital outflow S r 1 r 1 D NCO LF NCO 51

Analysis of a Quota on Cars from Japan Since NCO is unchanged, S curve does not shift. The D curve shifts: At each E, imports of cars fall, so net exports rise, D shifts to the right. At E 1, there is excess demand in the foreign exchange market. E rises to restore eq m. E 2 E 1 E Market for foreigncurrency exchange S = NCO D 1 D 2 Dollars 52

Analysis of a Quota on Cars from Japan What happens to NX? Nothing!! If E could remain at E 1, NX would rise, and the quantity of dollars demanded would rise.! But the import quota does not affect NCO, so the quantity of dollars supplied is fixed.! Since NX must equal NCO, E must rise enough to keep NX at its original level.! Hence, the policy of restricting imports does not reduce the trade deficit. 53

Analysis of a Quota on Cars from Japan Does the policy save jobs? The quota reduces imports of Japanese autos.! U.S. consumers buy more U.S. autos.! U.S. automakers hire more workers to produce these extra cars.! So the policy saves jobs in the U.S. auto industry. But E rises, reducing foreign demand for U.S. exports.! Export industries contract, exporting firms lay off workers. The import quota saves jobs in the auto industry but destroys jobs in U.S. export industries!! 54

CASE STUDY: Capital Flows from China! In recent years, China has accumulated U.S. assets to reduce its exchange rate and boost its exports.! Results in U.S.:! Appreciation of $ relative to Chinese renminbi! Higher U.S. imports from China! Larger U.S. trade deficit! Some U.S. politicians want China to stop, argue for restricting trade with China to protect some U.S. industries.! Yet, U.S. consumers benefit, and the net effect of China s currency intervention is probably small. 55

Political Instability and Capital Flight! 1994: Political instability in Mexico made world financial markets nervous.! People worried about the safety of Mexican assets they owned.! People sold many of these assets, pulled their capital out of Mexico.! Capital flight: a large and sudden reduction in the demand for assets located in a country! We analyze this using our model, but from the perspective of Mexico, not the U.S. 56

Capital Flight from Mexico The equilibrium values of r and NCO both increase. r Loanable funds r Net capital outflow S 1 r 2 r 2 r 1 r 1 D 1 D 2 LF NCO 2 NCO 1 NCO 57

Capital Flight from Mexico The increase in NCO causes an increase in the supply of pesos in the foreign exchange market. The real exchange rate value of the peso falls. E 1 E 2 E Market for foreigncurrency exchange S 1 = NCO 1 S 2 = NCO 2 D 1 Pesos 58

Examples of Capital Flight: Mexico, 1994 59

Examples of Capital Flight: S.E. Asia, 1997 60

Examples of Capital Flight: Russia, 1998 61

Examples of Capital Flight: Argentina, 2002 62

CONCLUSION! The U.S. economy is becoming increasingly open:! Trade in g&s is rising relative to GDP.! Increasingly, people hold international assets in their portfolios and firms finance investment with foreign capital. 63

CONCLUSION! Yet, we should be careful not to blame our problems on the international economy.! Our trade deficit is not caused by other countries unfair trade practices, but by our own low saving.! Stagnant living standards are not caused by imports, but by low productivity growth.! When politicians and commentators discuss international trade and finance, the lessons of this and the preceding chapter can help separate myth from reality. 64

Summary Net exports equal exports minus imports. Net capital outflow equals domestic residents purchases of foreign assets minus foreigners purchases of domestic assets. Every international transaction involves the exchange of an asset for a good or service, so net exports equal net capital outflow.

Summary Saving can be used to finance domestic investment or to buy assets abroad. Thus, saving equals domestic investment plus net capital outflow. The nominal exchange rate is the relative price of the currency of two countries. The real exchange rate is the relative price of the goods and services of the two countries.

Summary According to the theory of purchasing-power parity, a unit of any country s currency should be able to buy the same quantity of goods in all countries. This theory implies that the nominal exchange rate between two countries should equal the ratio of the price levels in the two countries. It also implies that countries with high inflation should have depreciating currencies.

Summary In an open economy, the real interest rate adjusts to balance the supply of loanable funds (saving) with the demand for loanable funds (domestic investment and net capital outflow). In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (net capital outflow) with the demand for dollars (net exports). Net capital outflow is the variable that connects these markets. 2015 Cengage 2015 Cengage Learning. Learning. All Rights All Reserved. Rights Reserved. May not May be copied, not be copied, scanned, scanned, or duplicated, or duplicated, in whole in or whole in part, or in except part, for except use as for use as permitted permitted in a license in a distributed license distributed with a certain with a product certain product or service or or service otherwise or otherwise on a on a password-protected website website for classroom for classroom use. use. 68

Summary A budget deficit reduces national saving, drives up interest rates, reduces net capital outflow, reduces the supply of dollars in the foreign exchange market, appreciates the exchange rate, and reduces net exports. A policy that restricts imports does not affect net capital outflow, so it cannot affect net exports or improve a country s trade deficit. Instead, it drives up the exchange rate and reduces exports as well as imports. 2015 Cengage 2015 Cengage Learning. Learning. All Rights All Reserved. Rights Reserved. May not May be copied, not be copied, scanned, scanned, or duplicated, or duplicated, in whole in or whole in part, or in except part, for except use as for use as permitted permitted in a license in a distributed license distributed with a certain with a product certain product or service or or service otherwise or otherwise on a on a password-protected website website for classroom for classroom use. use. 69

Summary Political instability may cause capital flight, as nervous investors sell assets and pull their capital out of the country. As a result, interest rates rise and the country s exchange rate falls. This occurred in Mexico in 1994 and in other countries more recently. 2015 Cengage 2015 Cengage Learning. Learning. All Rights All Reserved. Rights Reserved. May not May be copied, not be copied, scanned, scanned, or duplicated, or duplicated, in whole in or whole in part, or in except part, for except use as for use as permitted permitted in a license in a distributed license distributed with a certain with a product certain product or service or or service otherwise or otherwise on a on a password-protected website website for classroom for classroom use. use. 70