The Open Economy - Boston College · CHAPTER 6 The Open Economy 11 U.S.: the world’s largest...
Transcript of The Open Economy - Boston College · CHAPTER 6 The Open Economy 11 U.S.: the world’s largest...
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Modified for ECON 2204 by Bob Murphy
The Open Economy
MacroeconomicsN. Gregory Mankiw
© 2019 Worth Publishers, all rights reserved
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IN THIS CHAPTER, YOU WILL LEARN:
§ 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
1
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Imports and exports of selected countries, 2013
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3CHAPTER 6 The Open Economy
In an open economy,
§ spending need not equal output
§ saving need not equal investment
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4CHAPTER 6 The Open Economy
Preliminaries
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
d fC C C= +d fI I I= +d fG G G= +
superscripts:d = spending on
domestic goods
f = spending on foreign goods
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5CHAPTER 6 The Open Economy
GDP = Expenditure on
domestically produced g&s
d d dY C I G EX= + + +
( ) ( ) ( )f f fC C I I G G EX= − + − + − +
( )f f fC I G EX C I G= + + + − + +
C I G EX IM= + + + −
C I G NX= + + +
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6CHAPTER 6 The Open Economy
The national income identity
in an open economy
Y = C + I + G + NX
or, NX = Y – (C + I + G )
net exportsdomestic spending
output
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7CHAPTER 6 The Open Economy
Trade surpluses and deficits
§ 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
NX = EX – IM = Y – (C + I + G )
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8CHAPTER 6 The Open Economy
International capital flows
§ Net capital outflow= S – I
= net outflow of “loanable funds”
= net purchases of foreign assetsthe country’s purchases of foreign assets minus foreign purchases of domestic assets
§ When S > I, country is a net lender
§ When S < I, country is a net borrower
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9CHAPTER 6 The Open Economy
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 ).
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Saving, investment, and
the trade balance 1960–2014
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11CHAPTER 6 The Open Economy
U.S.: the world’s largest debtor nation
§ Every year since the 1980s: huge trade deficits and net capital inflows, i.e., net borrowing from abroad
§ As of 12/31/2014:
§ U.S. residents owned $24.7 trillion worth of foreign assets
§ Foreigners owned $31.6 trillion worth of U.S. assets
§ U.S. net indebtedness to rest of the world:$6.9 trillion—higher than any other country, hence U.S. is the “world’s largest debtor nation”
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12CHAPTER 6 The Open Economy
Saving and investment in a
small open economy
§ An open-economy version of the loanable funds model from Chapter 3.
§ 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= =,
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13CHAPTER 6 The Open Economy
National saving:
The supply of loanable funds
r
S, I
As in Chapter 3,national saving does not depend on the
interest rate
( )S Y C Y T G= − − −
S
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14CHAPTER 6 The Open Economy
Assumptions about 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
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15CHAPTER 6 The Open Economy
Investment:
The demand for loanable funds
Investment is still a downward-sloping functionof the interest rate,
r*
but the exogenous world interest rate…
…determines thecountry’s level ofinvestment.
I (r*)
r
S, I
I (r )
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16CHAPTER 6 The Open Economy
If the economy were closed . . .
r
S, I
I (r )
S
rc
cISr
=( )
. . . the interest rate would adjust to equate investment and saving.
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17CHAPTER 6 The Open Economy
But in a small open economy…
r
S, I
I (r )
S
rc
r*
I 1
the exogenous world interest rate determines investment…
…and the difference between saving and investment determines net capital outflow and net exports
NX
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18CHAPTER 6 The Open Economy
The nominal exchange rate
e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency
(e.g., yen per dollar)
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19CHAPTER 6 The Open Economy
A few exchange rates, as of 1/13/2015
country exchange rate
Euro area 0.85 euro/$
Indonesia 12,576 rupiahs/$
Japan 118.0 yen/$
Mexico 14.6 pesos/$
Russia 65.85 rubles/$
South Africa 11.50 rand/$
U.K. 0.66 pounds/$
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20CHAPTER 6 The Open Economy
The real exchange rate
= real exchange rate, the relative price of domestic goods in terms of foreign goods
(e.g. Japanese Big Macs per U.S. Big Mac)
the lowercase Greek letter
epsilon
ε
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21CHAPTER 6 The Open Economy
Understanding the units of ε
(Yen per $) ($ per unit U.S. goods)Yen per unit Japanese goods
×=
Units of Japanese goods
per unit of U.S. goods=
Yen per unit U.S. goodsYen per unit Japanese goods
=
*e PP×=ε
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22CHAPTER 6 The Open Economy
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.
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23CHAPTER 6 The Open Economy
How NX depends on ε
If ε rises:
§ U.S. goods become more expensive
relative to foreign goods
§ exports fall, imports rise
§ net exports fall
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U.S. net exports and the real exchange rate, 1973–2015
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25CHAPTER 6 The Open Economy
The net exports function
§ The net exports function reflects this inverse
relationship between NX and ε :
NX = NX(ε )
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26CHAPTER 6 The Open Economy
The NX curve for the U.S.
0 NX
ε
NX(ε)
ε1
When ε is relatively low, U.S. goods are relatively inexpensive
NX(ε1)
so U.S. net exports will be high.
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27CHAPTER 6 The Open Economy
The NX curve for the U.S.
0 NX
ε
NX(ε)
ε2
At high enough values of ε, U.S. goods become so expensive that
NX(ε2)
we export less than we import.
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28CHAPTER 6 The Open Economy
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= −
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29CHAPTER 6 The Open Economy
How ε is determined
Neither S nor Idepends on ε, so the net capital outflow curve is vertical.
ε
NX
NX(ε)
1 ( *)S I r−
ε adjusts to equate NXwith net capital outflow, S − I.
ε1
NX1
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30CHAPTER 6 The Open Economy
Interpretation: supply and demand
in the foreign exchange market
Demand:Foreigners need dollars to buy U.S. net exports.
ε
NX
NX(ε)
1 ( *)S I r−
Supply: Net capital outflow (S − I ) is the supply of dollars to be invested abroad.
ε1
NX1
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31CHAPTER 6 The Open Economy
Four experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand(exercise)
4. Trade policy to restrict imports
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32CHAPTER 6 The Open Economy
1. Fiscal policy at home
A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars in the foreign exchange market…
…causing the real exchange rate to rise and NX to fall.
ε
NX
NX(ε )
1 ( *)S I r−
ε1
NX1NX2
2 ( *)S I r−
ε2
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NX and the federal budget deficit (% of GDP), 1965–2014
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34CHAPTER 6 The Open Economy
2. Fiscal policy abroad
An increase in r*reduces investment, increasing net capital outflow and the supply of dollars in the foreign exchange market…
…causing the real exchange rate to fall and NX to rise.
ε
NX
NX(ε )
1 1( *)S I r−
NX1
ε1
21 ( )*S I r−
ε2
NX2
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NOW YOU TRY
3. Increase in investment demand
35
NX(ε )
ε1
1 1S I−
NX1
ε
NX
Determine the impact of an increase in investment demand on net exports, net capital outflow, and the real exchange rate.
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ANSWERS
3. Increase in investment demand
36
An increase in investment reduces net capital outflow and the supply of dollars in the foreign exchange market…
NX(ε )
ε1
1 1S I−
NX1
21S I−
NX2
ε2
ε
NX…causing the real exchange rate to rise and NX to fall.
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37CHAPTER 6 The Open Economy
4. Trade policy to restrict imports
ε
NX
NX(ε)1
S I−
NX1
ε1
NX(ε)2
At any given ε, an import quota reduces IM, increases NX, increases demand for dollars.
Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remain fixed.
ε2
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38CHAPTER 6 The Open Economy
4. Trade policy to restrict imports
ε
NX
NX(ε)1
S I−
NX1
ε1NX(ε)2
Results:Δε> 0
(demand increase)
ΔNX = 0(supply fixed)
ΔIM < 0 (policy)
ΔEX < 0(rise in ε )
ε2
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39CHAPTER 6 The Open Economy
The determinants of the
nominal exchange rate
§ Start with the expression for the real exchange rate:
*e Pε P×=
§ Solve for the nominal exchange rate:*Pe ε P= ×
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40CHAPTER 6 The Open Economy
The determinants of the
nominal exchange rate
( * , )M L r YP
= +π( ) ( )*NX ε S I r= −
§ So edepends on the real exchange rate and the price levels at home and abroad . . .
and we know how each of them is determined:
*Pe ε P= ×
** *
* ( * *, )M L r YP
= + π
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41CHAPTER 6 The Open Economy
The determinants of the
nominal exchange rate
§ Rewrite this equation in growth rates (see “arithmetic tricks for working with percentage changes,” Chapter 2 ):
*Pe ε P= ×
*
*e ε P Pe ε P P
= + −Δ Δ Δ Δ *εε
π π= + −Δ
§ For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates.
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Inflation differentials and nominal exchange rates for a cross section of countries
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43CHAPTER 6 The Open Economy
Purchasing Power Parity (PPP)
Two definitions:
§ A doctrine that states that goods must sell at the same (currency-adjusted) price in all countries.
§ The nominal exchange rate adjusts to equalize the cost of a basket of goods across countries.
Reasoning:
§ arbitrage, the law of one price
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44CHAPTER 6 The Open Economy
Purchasing Power Parity (PPP)
§ PPP: e � P = P*
Cost of a basket of domestic goods, in foreign currency.
Cost of a basket of domestic goods, in domestic currency.
Cost of a basket of foreign goods, in foreign currency.
§ Solve for e: e = P*/ P
§ PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels.
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45CHAPTER 6 The Open Economy
Purchasing Power Parity (PPP)
§ If e = P*/P,
then *
* * 1P P Pε e P P P= × = × =
and the NX curve is horizontal:
ε
NX
NXε= 1
S − I Under PPP,
changes in (S – I ) have no impact on ε or e.
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46CHAPTER 6 The Open Economy
Does PPP hold in the real world?
No, for two reasons:
1. International arbitrage not possible
§ nontraded goods
§ transportation costs
2. Different countries’ goods not perfect substitutes
Yet, PPP is a useful theory:
§ It’s simple & intuitive.
§ In the real world, nominal exchange rates tend toward their PPP values over the long run.
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no change
no change
i
h
i
h
h
i
no change
no change
i
h
h
i
i
h
i
h
129.4
-2.0
19.4
6.3
17.4
3.9
115.1
-0.3
19.9
1.1
19.6
2.2
closed economy
small open economy
actual change
ε
NX
I
r
S
G – T
1980s1970s
Data: Decade averages; all except r and ε are expressed as a percent of GDP; εis a trade-weighted index.
CASE STUDY:
The Reagan Deficits Revisited
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48CHAPTER 6 The Open Economy
The U.S. as a large open economy
§ So far, we’ve learned long-run models for two extreme cases:
§ closed economy (Chapter 3)
§ small open economy (Chapter 5)
§ A large open economy—like the U.S.—fallsbetween these two extremes.
§ The results from large open economy analysis are a mixture of the results for the closed & small open economy cases.
§ For example . . .
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49CHAPTER 6 The Open Economy
NX
I
r
large open economy
small open economy
closed economy
A fiscal expansion in three models
falls, but not as much as in small open economy
fallsno
change
falls, but not as much as in closed economy
nochange
falls
rises, but not as much as in closed economy
nochange
rises
A fiscal expansion causes national saving to fall.The effects of this depend on openness & size.