9/16/2013 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 CCdf C d = spending on df domestic goods . saving need not equal investment II I f = spending on GGdf 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 CHAPTER 5 The Open Economy 4 CHAPTER 5 The Open Economy 5 1 9/16/2013 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 the tra de 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 CHAPTER 5 The Open Economy 6 CHAPTER 5 The Open Economy 7 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 asse ts . 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” CHAPTER 5 The Open Economy 10 CHAPTER 5 The Open Economy 11 2 9/16/2013 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 CHAPTER 5 The Open Economy 16 CHAPTER 5 The Open Economy 17 3 9/16/2013 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 CHAPTER 5 The Open Economy 20 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 CHAPTER 5 The Open Economy 23 4 9/16/2013 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 CHAPTER 5 The Open Economy 28 CHAPTER 5 The Open Economy 29 5 9/16/2013 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 CHAPTER 5 The Open Economy 34 CHAPTER 5 The Open Economy 35 6 9/16/2013 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. CHAPTER 5 The Open Economy 36 CHAPTER 5 The Open Economy 37 1.