CHAPTER 19 Theory of the Open Economy - TTUmyweb.ttu.edu/kbecker/macro-ch19-presentation7e.pdf · A...

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Seventh Edition

MacroeconomicsPrinciples of

N. Gregory Mankiw

CHAPTER

19A Macroeconomic

Theory of the Open Economy

Woj

ciec

h Ge

rson

(183

1-19

01)

Presenter

Presentation Notes

Many instructors skip this chapter. I encourage you to consider keeping it: it sheds light on some of the most important and compelling topics in economics, and I have worked hard to make this PowerPoint easy to teach and easy to learn. Students will learn in this chapter what I believe is one of the most important lessons economics has to offer the educated layperson: Trade policies designed to save jobs in one industry do so only by destroying jobs in other industries. This case against restricting imports has a much greater emotional impact on students than the deadweight loss triangles students learn in their micro courses. The chapter also covers capital flight, the twin deficits, and capital flows from China.

In this chapter, look for the answers to these questions

• In an open economy, what determines the real interest rate? The real exchange rate?

• How are the markets for loanable funds and foreign-currency exchange connected?

• How do government budget deficits affect the exchange rate and trade balance?

• How do other policies or events affect the interest rate, exchange rate, and trade balance?


2© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Introduction The previous chapter explained the basic

concepts and vocabulary of the open economy:net exports (NX), net capital outflow (NCO), and exchange rates.

This chapter ties these concepts together into 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…


The Market for Loanable Funds An identity from the preceding chapter:

S = I + NCOSaving 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


The Market for Loanable Funds Recall: S depends positively on the real interest rate, r. I depends negatively on r.

What about NCO?


5

How NCO Depends on the Real Interest RateThe 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

NCO

NCO

r2

Net capital outflow

r1

NCO1 NCO2


6

D = I + NCO

r adjusts to balance supply and demand in the LF market.

The Loanable Funds Market Diagram

r

LF

S = saving

Loanable funds

r1

Both I and NCOdepend negatively on r,

so the D curve is downward-sloping.

A C T I V E L E A R N I N G 1Budget 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.


A C T I V E L E A R N I N G 1Answers


The higher r makes U.S. bonds more attractive relative to foreign bonds, reduces NCO. A budget deficit reduces saving and the supply of LF, causing r to rise.

D1

r

NCO

NCO1

Net capital outflowr

LF

S1

Loanable funds

r1

S2

r2r2

r1

When working with this model, keep in mind:the LF market determines r (in left graph),

then this value of r determines NCO (in right graph).


9

The Market for Foreign-Currency Exchange

Another identity from the preceding chapter:NCO = NX

Net exportsNet capital

outflow

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.

Presenter

Presentation Notes

That NX = demand for dollars and NCO = supply of dollars is critically important. Make sure to allow enough time for students to write this down in their notes.


10


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.


11

S = NCO


E

Dollars

D = NX

E1

An increase in Ehas no effect on saving or investment, so it does not affect NCO or the supply of dollars.

E adjusts to balance supply and demand for dollars in the market for foreign-currency exchange.

An increase in E makes U.S. goods more expensive to foreigners, reduces foreign demand for U.S. goods—and U.S. dollars.

Presenter

Presentation Notes

The textbook has good intuition explaining why the S/NCO curve is vertical rather than positively sloped. Here’s a quick summary: If E rises, our dollars can buy more foreign assets (perhaps 60,000 pesos worth of Mexican bonds instead of 50,000). Yet, what we care about is the rate of return on foreign assets. This return does not depend on whether E is high or low.


12

FYI: Disentangling Supply and DemandWhen a U.S. resident buys imported goods, does the transaction affect supply or demand in the foreign exchange market? Two views: 1. The supply of dollars increases.

The person needs to sell her dollars to obtain the foreign currency she needs to buy the imports.

2. The demand for dollars decreases.The increase in imports reduces NX, which we think of as the demand for dollars.(So, NX is really the net demand for dollars.)

Both views are equivalent. For our purposes, it’s more convenient to use the second.

Presenter

Presentation Notes

It might be worth elaborating for a moment on the parenthetical remark: “So, NX is really the net demand for dollars.” What we mean is that NX equals foreign demand for dollars to purchase U.S. exports minus U.S. supply of dollars to purchase imports.


13

FYI: Disentangling Supply and DemandWhen a foreigner buys a U.S. asset, does the transaction affect supply or demand in the foreign exchange market? Two views: 1. The demand for dollars increases.

The foreigner needs dollars in order to purchase the U.S. asset.

2. The supply of dollars falls.The transaction reduces NCO, which we think of as the supply of dollars. (So, NCO is really the net supply of dollars.)

Again, both views are equivalent. We will use the second.

Presenter

Presentation Notes

Again, please consider elaborating on the parenthetical remark: “So, NCO is really the net supply of dollars.” It means that NCO equals U.S. supply of dollars to purchase foreign assets minus foreign demand for dollars to purchase U.S. assets.

A C T I V E L E A R N I N G 2Budget 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?


Presenter

Presentation Notes

This exercise, like the previous one, lets students work with one piece of the larger model before putting all the pieces together.



The budget deficit reduces NCO and the supply of dollars.

The real exchange rate appreciates,

reducing net exports.

Since NX = 0 initially, the budget deficit causes a trade deficit (NX < 0).

S1 = NCO1E

Dollars

D = NX

E1

S2 = NCO2

E2

Market for foreign-currency exchange

The “Twin Deficits”

Net exports and the budget deficit often move in opposite directions.

-5%-4%-3%-2%-1%0%1%2%3%4%5%6%

1961

-65

1966

-70

1971

-75

1976

-80

1981

-85

1986

-90

1991

-95

1996

-200

0

2001

-200

5

2006

-201

0

Perc

ent o

f GD

P

U.S. federal budget deficit

U.S. net exports

Presenter

Presentation Notes

Data are 5-year averages of quarterly data. (This model applies to the long run, so using high-frequency data is not appropriate.) Of course, there is not a perfect negative correlation. Other factors affect the trade deficit besides the budget deficit. For example, consider the recession of 1990–91. The budget deficit increased, as usual in recessions, due to the fall in tax revenues and rise in automatic-stabilizer spending (like unemployment insurance benefits). Net exports increased (i.e., the trade deficit fell) due to a fall in imports. During the expansion of 1995–2000, the improving economy and surging stock market caused tax revenues to rise, which brought the deficit down, and income growth caused consumer demand for imports to rise, bringing net exports down. But more generally, the data show that increases in the budget deficit are associated with decreases in the trade balance, as students found using the model in the preceding Active Learning exercises. Source: Bureau of Economic Analysis, Department of Commerce. I got the data from http://research.stlouisfed.org/fred2/ Series: FGEXPND = federal govt expenditures FGRECPT = federal govt receipts EXPGS = exports of goods and services IMPGS = imports of goods and services GDP


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).


18

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 $25.8 trillion

U.S.’ net debt to the rest of the world $ 4.2 trillion

Presenter

Presentation Notes

The last figure in the table, the U.S.’ net debt to the rest of the world, is bigger than any other country’s net debt to the rest of the world. Hence the expression “the U.S. is the world’s biggest debtor nation.” Source: Bureau of Economic Analysis, Department of Commerce


19

The Connection Between Interest Rates and Exchange Rates

r

NCO

E

dollars

NCO

D = NX

S1 = NCO1S2

E1

E2

r1

r2

Anything that increases rwill reduce NCOand the supply of dollars in the foreign exchange market. Result: The real exchange rate appreciates.

NCO1NCO2

NCO1NCO2

Keep in mind:The LF market (not shown)

determines r. This value of r

then determines NCO (shown in upper graph).This value of NCO then

determines supply of dollars in foreign exchange

market (in lower graph).

Presenter

Presentation Notes

In earlier slides, students analyzed the effects of a budget deficit on the real interest rate and net capital outflow separately from the effects of a change in NCO on the exchange rate. This slide makes the connection between these events more explicit. Please point out to your students that both diagrams measure the same units on the horizontal axis. This slide also reviews the order and direction of causality among the three diagrams: 1. The LF market determines the equilibrium value of r. 2. This value of r and the NCO curve determine the equilibrium value of NCO. 3. This value of NCO determines the position of the vertical supply curve in the foreign exchange market. 4. The real exchange rate adjusts to equate demand (net exports) with supply (NCO) in the foreign exchange market. Students are much less likely to answer exam questions incorrectly if they carefully study this order and direction of causality among the various parts of this complicated model.

A C T I V E L E A R N I N G 3Investment 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


Presenter

Presentation Notes

Students should find this policy experiment familiar; it was covered in the closed-economy loanable funds model from the chapter “Saving, Investment, and the Financial System.”



D1

r

NCO

NCO


LF

S1

Loanable funds

r1 r1

r2

D2

r2

r rises, causing NCO to fall.

NCO1NCO2

Investment—and the demand for LF—increase at each value of r.



The fall in NCOreduces the supply of dollars in the foreign exchange market.

The real exchange rate appreciates,

reducing net exports.

S1 = NCO1E

Dollars

D = NX

E1

S2 = NCO2

E2



Budget Deficit vs. Investment Incentives A tax incentive for investment has similar effects

as a budget deficit: r rises, NCO falls E rises, NX falls

But one important difference: Investment tax incentive increases investment,

which increases productivity growth and living standards in the long run. Budget deficit reduces investment,

which reduces productivity growth and living standards.


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


25

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.


26

D

An import quota does not affect saving or investment, so it does not affect NCO. (Recall: NCO = S – I.)

Analysis of a Quota on Cars from Japan

r

NCO

NCO


LF

S

Loanable funds

r1 r1

Presenter

Presentation Notes

The supply of loanable funds is saving, which equals Y – C – G. A quota on imports does not affect Y or C or G, so it will not affect saving. The demand for loanable funds equals investment + NCO, neither of which are affected by import quotas. Hence, r will not change. The NCO curve does not shift in response to the import quota. The import quota is a restriction on international trade in goods & services. The NCO curve describes international trade in assets. Hence, the equilibrium value of NCO is not affected by the import quota.


27


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 E1, there is excess demand in the foreign exchange market.

E rises to restore eq’m.

S = NCOE

Dollars

D1

E1


D2

E2


28


What happens to NX? Nothing! If E could remain at E1, 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.

Presenter

Presentation Notes

The import quota on cars from Japan ends up having almost no macroeconomic effects. In particular, it does not affect the equilibrium values of r, S, I, NCO, or NX. The only macro variable affected by the import quota is E, the real exchange rate. Yet, the policy does have important microeconomic effects, as the next slide discusses.


29

Analysis of a Quota on Cars from JapanDoes 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!!

Presenter

Presentation Notes

A restriction on imports has important microeconomic effects. It shifts demand to domestic autos, boosting output and employment in that industry. But the exchange rate appreciation reduces foreign demand for U.S. exports, depressing output and employment in those industries. If students have taken a semester of microeconomics, they have probably seen the deadweight loss triangles resulting from tariffs and quotas. On an intellectual level, they may understand what these deadweight losses represent. But job losses in struggling import-competing industries make a powerful impression on students. The analysis here shows that the jobs import restrictions save come at the expense of other jobs. Understanding this lesson shatters the most common populist reason for supporting protectionism. Also, if students remember anything about comparative advantage, they should understand that productivity is probably higher in the export sector, so wages are higher in the export sector, too. So it really doesn’t make sense to destroy good jobs in the export sector in order to save jobs in the lower-productivity import-competing sector.


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.

Presenter

Presentation Notes

This slide is based on a Case Study in the textbook.


31

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.


32

The equilibrium values of r and NCO both increase.As foreign investors sell their assets and pull out their capital, NCO increases at each value of r.Demand for LF = I + NCO. The increase in NCO increases demand for LF.

D1

Capital Flight from Mexico

r

NCO

NCO1

r1


LF

S1

r1

Loanable funds

D2

r2

NCO2

r2

Presenter

Presentation Notes

Students may ask “How can you be sure that NCO rises? Doesn’t the increase in r cause NCO to fall?” You can convince them that NCO rises using simple algebra: S = I + NCO NCO = S – I ΔNCO = ΔS – ΔI where, for any variable X, ΔX = the change in X from one equilibrium to another. Because r is higher in the new equilibrium, ΔS > 0 and ΔI < 0 Hence, it must be true that ΔNCO > 0. So, the increase in r reduces NCO somewhat, but not enough to reverse the initial capital outflow.


33

Capital Flight from Mexico

The increase in NCOcauses an increase in the supply of pesos in the foreign exchange market.

The real exchange rate value of the peso falls.

S2 = NCO2


E

Pesos

D1

S1 = NCO1

E1

E2

Examples of Capital Flight: Mexico, 1994

0.10

0.15

0.20

0.25

0.30

0.35

10/2

3/19

94

11/1

2/19

94

12/2

/199

4

12/2

2/19

94

1/11

/199

5

1/31

/199

5

2/20

/199

5

3/12

/199

5

4/1/

1995

US

Dol

lars

per

cur

renc

y un

it .

Presenter

Presentation Notes

The textbook briefly discusses four recent examples of capital flight. Here are a few slides showing the behavior of the exchange rate in each episode.

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

0

20

40

60

80

100

120

12/1

/199

6

2/24

/199

7

5/20

/199

7

8/13

/199

7

11/6

/199

7

1/30

/199

8

4/25

/199

8

7/19

/199

8

US

Dol

lars

per

cur

renc

y un

it.1/

1/19

97 =

100

South Korea WonThai BahtIndonesia Rupiah

Examples of Capital Flight: Russia, 1998

0.00

0.04

0.08

0.12

0.16

0.20

5/5/

1998

6/14

/199

8

7/24

/199

8

9/2/

1998

10/1

2/19

98

11/2

1/19

98

12/3

1/19

98

US

Dol

lars

per

cur

renc

y un

it .

Examples of Capital Flight: Argentina, 2002

0.0

0.2

0.4

0.6

0.8

1.0

1.27/

1/20

01

9/19

/200

1

12/8

/200

1

2/26

/200

2

5/17

/200

2

8/5/

2002

10/2

4/20

02

1/12

/200

3

U.S

. Dol

lars

per

cur

renc

y un

it .


38

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.


39

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.

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.


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.


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.


CHAPTER 19 Theory of the Open Economy - TTUmyweb.ttu.edu/kbecker/macro-ch19-presentation7e.pdf · A...

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