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Imports and exports (% of GDP), 2007 Chapter 5: Open Economy 45% Imports 40% Exports 35%

30%

25%

20%

15%

10%

5%

0% CHAPTER 1 The Science of Macroeconomics 0 Canada France Germany Italy Japan U.K. U.S.

In an open economy, Preliminaries superscripts: . spending need not equal output CCdf C d = spending on

df domestic goods . saving need not equal investment II  I f = spending on GGdf G foreign goods 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

CHAPTER 5 The Open Economy 2 CHAPTER 5 The Open Economy 3

GDP = expenditure on The national income identity domestically produced g & s in an open economy

Y CIGEXdd d Y = C + I + G + NX ()()()CCff  II  GG f  EX or, NX = Y –(C + I + G ) CIGEXC ()ff  I  G f domestic CIGEXIM  spending net exports CIGNX output

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Trade surpluses and deficits International capital flows

NX = EX – IM = Y –(C + I + G ) . Net capital outflow = S – I . trade surplus: = net outflow of “loanable funds” output > spending and exports > imports Size o f th e trad e surp lus = NX = net purchases of foreign assets the country’s purchases of foreign assets . trade deficit: minus foreign purchases of domestic assets spending > output and imports > exports Size of the trade deficit = –NX . When S > I, country is a net lender . When S < I, country is a net borrower

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Saving, investment, and the trade balance The link between trade & cap. flows (percent of GDP) 1960-2007 24% 8%

NX = Y –(C + I + G ) 22% investment 6% implies 20% 4% NX = (Y – C – G ) – I 18%

= S – I 16% 2% saving trade balance = net capital outflow 14% 0%

12% Thus, -2% a country with a trade deficit (NX < 0) 10% -4% 8% trade balance is a net borrower (S < I ). (right scale) 6% -6% CHAPTER 5 The Open Economy 8 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

U.S.: “The world’s largest debtor nation” Saving and investment in a small open economy . Every year since 1980s: huge trade deficits and net capital inflows, i.e. net borrowing from abroad . An open-economy version of the loanable funds model from Chapter 3. . As of 12/31/2008: . U.S. residents owned $19.9 trillion worth of . Includes many of the same elements: fiforeign asset s . production function Y YFKL(,) . Foreigners owned $23.4 trillion worth of consumption function U.S. assets . CCYT() . U.S. net indebtedness to rest of the world: . investment function IIr () $3.5 trillion--higher than any other country, . exogenous policy variables GGTT, hence U.S. is the “world’s largest debtor nation”

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National saving: Assumptions about capital flows The supply of loanable funds a. domestic & foreign bonds are perfect substitutes r SYCYT()   G (same risk, maturity, etc.) b. perfect capital mobility: As in Chapter 3, national saving does no restrictions on international trade in assets not depend on the c. economy is small: interest rate cannot affect the world interest rate, denoted r*

a & b imply r = r* S S, I c implies r* is exogenous

CHAPTER 5 The Open Economy 12 CHAPTER 5 The Open Economy 13

Investment: If the economy were closed… The demand for loanable funds r S r Investment is still a …the interest downward-sloping function rate would of the interest rate, adjust to but the exogenous equate world in teres t ra te… investment r* …determines the and saving: rc country’s level of investment. I(r ) I (r )

I ()rc S, I I (r* ) S, I  S

CHAPTER 5 The Open Economy 14 CHAPTER 5 The Open Economy 15

But in a small open economy… Next, three experiments:

r 1. Fiscal policy at home the exogenous S world interest 2. Fiscal policy abroad rate determines NX investment… 3. An increase in investment demand r* (exercise) …and the difference rc between saving and investment I(r ) determines net capital outflow I 1 S, I and net exports

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NX and the federal budget deficit 1. Fiscal policy at home (% of GDP), 1965-2009 r 8% S S 2 1 Budget deficit An increase in G 2% 6% (left scale) or decrease in T NX2 reduces saving. * r1 4% 0%

NX1 Results: 2% I 0 -2% 0% NX S 0 I(r ) -4% I S, I -2% Net exports 1 (right scale)

-4% -6% CHAPTER 5 The Open Economy 18 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

NOW YOU TRY: 2. Fiscal policy abroad 3. An increase in investment demand r r Expansionary S 1 Use the S NX fiscal policy 2 model to * * abroad raises r2 determine r NX1 the world * the impact of interest rate. r1 an increase NX in investment 1 Results: demand on NX, S, I, and I 0 I(r ) I(r )1 net capital NX I 0 outflow. S, I I 1 S, I * Ir()* I ()r2 1

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ANSWERS: The nominal exchange rate 3. An increase in investment demand r S I > 0, NX 2 e = nominal exchange rate, S = 0, r * net capital the relative price of outflow and domestic currency NX fall NX1 in terms of foreign currency by the I(r )2 amount I (e.g. Yen per Dollar) I(r )1

I 1 I 2 S, I

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A few exchange rates, as of 6/24/2009 The real exchange rate

country exchange rate Euro area 0.72 Euro/$ ε = real exchange rate, the relative price of Indonesia 10,337 Rupiahs/$ the lowercase domestic goods Japan 95.9 Yen/$ GklGreek letter in terms of foreign goods Mexico 13.3 Pesos/$ epsilon (e.g. Japanese Big Macs per Russia 31.4 Rubles/$ U.S. Big Mac) South Africa 8.1 Rand/$ U.K. 0.61 Pounds/$

CHAPTER 5 The Open Economy 25

Understanding the units of ε ~ McZample ~

eP . one good: Big Mac ε  P * . price in Japan: (Yen per $) ($ per unit U.S. goods) P* = 200 Yen  Yen per unit Japanese goods . price in USA: P = $2.50 Yen per unit U.S. goods . nominal exchange rate  To buy a U.S. Big Mac, Yen per unit Japanese goods e = 120 Yen/$ someone from Japan eP ε  would have to pay an Units of Japanese goods P *  amount that could buy per unit of U.S. goods 120 $. 2 50 15. 1.5 Japanese Big Macs. 200 Yen

CHAPTER 5 The Open Economy 26 CHAPTER 5 The Open Economy 27

ε in the real world & our model How NX depends on ε

. In the real world: We can think of ε as the relative price of ε  U.S. goods become more expensive a basket of domestic goods in terms of a basket relative to foreign goods of foreign goods  EX, IM . In our macro model: There’s just one good, “output.”  NX So ε is the relative price of one country’s output in terms of the other country’s output

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U.S. net exports and the real exchange rate, 1973-2009 The net exports function 4% Trade-weighted real 140 exchange rate index . The net exports function reflects this inverse 2% 120 relationship between NX and ε: 100 0% ε 1973 = 100) NX = NX( ) of GDP) 80

(% -2% (March (March NX 60 -4%

40 Index Net exports -6% (left scale) 20

-8% 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 CHAPTER 5 The Open Economy 31

The NX curve for the U.S. The NX curve for the U.S.

ε ε At high enough values of ε, U.S. goods become ε2 so U.S. net so expensive that we export When ε is exports will relatively low, be high less than U.S. goods are we import relatively ε1 inexpensive NX(ε) NX(ε) 0 NX 0 NX NX(ε1) NX(ε2) CHAPTER 5 The Open Economy 32 CHAPTER 5 The Open Economy 33

How ε is determined How ε is determined

. The accounting identity says NX = S – I Neither S nor I SIr (*) depend on ε, ε 1 . We saw earlier how S – I is determined: so the net capital . S depends on domestic factors (output, fiscal outflow curve is policy variables, etc) vertical. . I is determined by the world interest ε 1 rate r* ε adjusts to . So, ε must adjust to ensure equate NX NX(ε ) with net capital outflow, S  I. NX NX ()ε SIr (* ) NX 1

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Interpretation: supply and demand Next, four experiments: in the foreign exchange market 1. Fiscal policy at home demand: SIr (*) ε 1 Foreigners need 2. Fiscal policy abroad dollars to buy U.S. net exports. 3. An increase in investment demand (exercise) supply: ε 1 4. Trade policy to restrict imports Net capital outflow (S  I ) NX(ε ) is the supply of NX dollars to be NX 1 invested abroad.

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1. Fiscal policy at home 2. Fiscal policy abroad

An increase in r* A fiscal expansion S 2  Ir(*) SIr11 (*) reduces reduces national ε SIr (*) ε SI ()r * 1 investment, 1 2 saving, net capital increasing net outflow, and the ε 2 capital outflow ε 1 supply of dollars and the supply of in the foreign dollars in the exchange ε 1 ε 2 foreign exchange market… NX(ε ) market… NX(ε ) …causing the real NX …causing the real NX exchange rate to NX 2 NX 1 NX 1 NX 2 rise and NX to fall. exchange rate to fall and NX to rise. CHAPTER 5 The Open Economy 38 CHAPTER 5 The Open Economy 39

NOW YOU TRY: ANSWERS: 3. Increase in investment demand 3. Increase in investment demand

An increase in S 1  I 2 Determine the ε investment ε SI11 SI11 impact of an reduces net increase in capital outflow ε 2 investment and the supply demand on of dollars in the net exports, ε 1 foreign ε 1 net capital exchange outflow, NX(ε ) market… NX(ε ) and the real NX …causing the real NX exchange rate NX 1 NX 2 NX 1 exchange rate to rise and NX to fall.

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4. Trade policy to restrict imports 4. Trade policy to restrict imports

At any given value of Results: SI SI ε, an import quota ε ε > 0 ε IM NX (demand  demand for increase) ε 2 ε 2 dollars shifts NX = 0

right ε 1 (supply fixed) ε 1

NX (ε )2 IM < 0 NX (ε )2 Trade policy doesn’t (policy) NX (ε )1 NX (ε )1 affect S or I , so EX < 0 capital flows and the NX NX NX (rise in ε ) NX supply of dollars 1 1 remain fixed. CHAPTER 5 The Open Economy 42 CHAPTER 5 The Open Economy 43

The determinants of the The determinants of the nominal exchange rate nominal exchange rate

. Start with the expression for the real exchange . So e depends on the real exchange rate and rate: eP the price levels at home and abroad… ε  P * …and we know how each M * of them is determined: Lr**( ** , Y) . SlSolve for the nom ina l exc hange ra te: P * P * P * e ε e ε P P M Lr(* , Y ) NX ()ε SIr (* ) P

CHAPTER 5 The Open Economy 44 CHAPTER 5 The Open Economy 45

The determinants of the Inflation differentials and nominal exchange nominal exchange rate rates for a cross section of countries P * % change 30% e ε in nominal Mexico P 25% exchange . Rewrite this equation in growth rates rate 20% (see “arithmetic tricks for working with percentage Iceland changes,” Chap 2 ): 15% * Pakistan e ε PPε * 10%     Australia S. Africa e ε PP* ε 5% Canada S. Korea . For a given value of ε, Singapore 0% U.K. the growth rate of e equals the difference Japan between foreign and domestic inflation rates. -5% -10% -5% 0% 5% 10% 15% 20% 25% 30% CHAPTER 5 The Open Economy 46 inflation differential

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Purchasing Power Parity (PPP) Purchasing Power Parity (PPP)

Two definitions: . PPP: e P = P* Cost of a basket of . A doctrine that states that goods must sell at the foreign goods, in foreign currency. same (currency-adjusted) price in all countries. . The nominal exchange rate adjusts to equalize Cost of a basket of Cost of a basket of thfbkfdhe cost of a basket of goods across countr ies. domestic goods, in domestic goods, in foreign currency. domestic currency. Reasoning: . arbitrage, the law of one price . Solve for e : e = P*/ P . PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels. CHAPTER 5 The Open Economy 48 CHAPTER 5 The Open Economy 49

Purchasing Power Parity (PPP) Does PPP hold in the real world?

. If e = P*/P, No, for two reasons: PP* P then 1. International arbitrage not possible. ε e **   1 PPP . nontraded goods and the NX curve is horizontal: . transportation costs ε 2. Different countries’ goods not perfect substitutes. S  I Under PPP, changes in Yet, PPP is a useful theory: (S – I ) have no It’s simple & intuitive. ε = 1 NX impact on ε or e. . . In the real world, nominal exchange rates tend toward their PPP values over the long run. NX

CHAPTER 5 The Open Economy 50 CHAPTER 5 The Open Economy 51

CASE STUDY: The Reagan deficits revisited The U.S. as a large open economy So far, we’ve learned long-run models for actual closed small open . 1970s 1980s change economy economy two extreme cases: . closed economy (chap. 3) G – T 2.2 3.9    . small open economy (chap. 5) S 19.6 17.4    . A large open economy – like the U. S. – falls r 1.1 6.3   no change between these two extremes. I 19.9 19.4   no change . The results from large open economy analysis NX -0.3 -2.0  no change  are a mixture of the results for the closed & small open economy cases. ε 115.1 129.4  no change 

Data: decade averages; all except r and ε are expressed as a percent of GDP; . For example… ε is a trade-weighted index. CHAPTER 5 The Open Economy 53

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A fiscal expansion in three models Chapter Summary A fiscal expansion causes national saving to fall. . Net exports--the difference between The effects of this depend on openness & size: . exports and imports closed large open small open . a country’s output (Y ) economy economy economy and its spending (C + I + G) rises, but not as much no r rises . Net capital outflow equals as in closed economy change . purchases of foreign assets falls, but not as much no I falls minus foreign purchases of the country’s as in closed economy change assets no falls, but not as much as . the difference between saving and investment NX falls change in small open economy

CHAPTER 5 The Open Economy 54

Chapter Summary Chapter Summary . National income accounts identities: . Exchange rates . Y = C + I + G + NX . nominal: the price of a country’s currency in . trade balance NX = S  I net capital outflow terms of another country’s currency . real: the price of a country’s goods in terms . IItfliimpact of policies on NX : of another country’ s goods . NX increases if policy causes S to rise . The real exchange rate equals the nominal or I to fall rate times the ratio of prices of the two . NX does not change if policy affects countries. neither S nor I. Example: trade policy

Chapter Summary Chapter Summary . How the real exchange rate is determined . How the nominal exchange rate is determined . NX depends negatively on the real exchange . e equals the real exchange rate times the rate, other things equal country’s price level relative to the foreign . The real exchange rate adjusts to equate price level. NX with net capital outflow . For a given value of the real exchange rate , the percentage change in the nominal exchange rate equals the difference between the foreign & domestic inflation rates.

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