Macroeconomics II The Large Open Economy Vahagn Jerbashian Ch. 5 from Mankiw (2010, 2003) Spring 2018
Net capital outflow In small open economy (with perfect capital mobility) interest rate is given by the rest of the world, r Capital flows in or out until the interest rate is equilibrated to r In large open economy capital flows also depend on the interest rate If interest rate is higher (lower) than in the rest of the world then capital flows in (out) This implies that net capital outflow, CF, is declining with the interest rate r CF = CF (r).
Net capital outflow Higher domestic interest rate reduces the domestic investments abroad and increases foreign investments at home. Therefore it reduces net capital outflow
Special cases Closed economy is a special case of a large open economy where simply CF = 0 The small open economy is a special case in the sense that capital flows freely in and out of the economy, but does not affect world interest rate
Special cases
Imperfect capital mobility In large open economy interest rate is not given by the rest of the world since its savings affect the world market In a small open economy with imperfect capital mobility interest rate might not be given by the rest of the world too For such an economy CF slopes downward The model presented in next few slides applies to large open economy and small open economy with imperfect capital mobility
Preliminaries The model consists of two markets: the market for loanable funds (where r is determined) and the market for foreign exchange (where RER is determined) r and RER are the prices that guide the allocation of resources at home and abroad In a small open economy with perfect capital mobility r is given and we do not focus on the market for loanable funds
Loanable funds market In an open economy savings are used to finance investments and net capital outflow S = I + CF Savings are given by the level of output, fiscal policies, and the consumption function Investments and capital outflow are both (declining) functions of interest rate S = I (r) + CF (r)
Loanable funds market At equilibrium interest rate savings (the domestic supply of loanable funds) are equal to the sum of investments (demand for loanable funds for domestic investments) and net capital outflow (capital investments abroad)
Foreign exchange market In an open economy the National Accounts Identity tells that NX = S I, therefore, NX (RER) = CF
Foreign exchange market
Equilibrium in the large open economy
Fiscal policy at home Consider an increase in government expenditures (G) and/or decrease of taxes (T ) Such a fiscal policy reduces savings and therefore reduces supply of loanable funds Lower supply of loanable funds increases interest rate r Higher interest rate reduces investments and net capital outflow Lower net capital outflow reduces the supply of domestic currency and therefore increases exchange rate
Fiscal policy at home
Fiscal policy at home Notice that the effect of fiscal policy in large open economy is a combination of effects of fiscal policy in closed economy and in small open economy This can be seen from the National Accounts Identity which implies that NX = S I In a closed economy lower savings simply imply lower investments and higher interest rate In a small open economy interest rate and investments are fixed Therefore, lower savings correspond simply to lower net exports In a large open economy lower savings reduce investments and net exports together
Trade policy Consider an increase in import quotas Such a trade policy increases net exports for any level of real exchange rate Since nothing has happened in loanable funds market interest rate remains the same This implies that investments and net capital outflow do not change Since net capital outflow does not change, in equilibrium net exports should remain the same Therefore, real exchange rate increases to reduce net exports
Trade policy
Investment policy Consider a policy that subsidizes investments Such a policy increases investments for any level of real interest rate Since savings remain constant, this increases equilibrium real interest rate Higher interest rate reduces net capital outflow Lower net capital outflow matches to higher real exchange rate
Investment policy
Investment policy Notice that this is, again, a combination of effects in a closed economy and in a small open economy In a closed economy interest rate simply would increase since savings do not change In a small open economy higher investments imply lower net exports and higher exchange rate, but interest rate does not change
Fiscal policy abroad Consider a decline in government expenditures (G) and/or increase of taxes (T ) in a foreign large open economy Such a policy increases savings in foreign large economy and therefore increases the supply of loanable funds there Higher supply of loanable funds reduces interest rate r abroad Lower interest rate abroad reduces net capital outflow for any domestic interest rate Lower net capital outflow reduces interest rate and increases investments Lower net capital outflow reduces the supply of domestic currency and increases exchange rate
Fiscal policy abroad
Fiscal policy abroad Again, these effects can be thought to be combinations of effects in a closed economy and small open economy In a closed economy policies abroad do not have any effects In a small open economy higher savings abroad increase investments and reduce by the same amount net exports
Summary In large open economy we consider an additional market, the market for loanable funds, since interest rate is not given This implies that policies affect the interest rate and net capital outflow However, most of the effects are simply averages of closed economy and small open economy effects