6 The Open Economy MACROECONOMICS N Gregory Mankiw

6 The Open Economy MACROECONOMICS N. Gregory Mankiw Power. Point ® Slides by Ron Cronovich © 2013 Worth Publishers, all rights reserved

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

Imports and exports of selected countries, 2010 60 Exports Percent of GDP 50 Imports 40 30 20 10 0 Australia China Germany Greece S. Korea Mexico United States

Imports and exports of Korea, 1997 - 2012 CHAPTER 6 The Open Economy 3 3

In an open economy, § spending need not equal output § saving need not equal investment CHAPTER 6 The Open Economy 4

Preliminaries superscripts: d = spending on domestic goods f = spending on 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 6 The Open Economy 5

GDP = expenditure on domestically produced g & s CHAPTER 6 The Open Economy 6

The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G ) domestic spending net exports output CHAPTER 6 The Open Economy 7

Trade surpluses and deficits NX = EX – IM = Y – (C + I + G ) § 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 CHAPTER 6 The Open Economy 8

International capital flows § Net capital outflow =S –I = net outflow of “loanable funds” = net purchases of foreign assets the 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 CHAPTER 6 The Open Economy 9

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 ). CHAPTER 6 The Open Economy 10

Saving, investment, and the trade balance 1960– 2012 investment 15% 20% 15% 5% saving 10% 0% 5% -5% trade balance (right scale) 0% -10% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Trade Balance (% of GDP) Saving, Investment (% of GDP) 25%

U. S. : The world’s largest debtor nation § Every year since 1980 s: huge trade deficits and net capital inflows, i. e. net borrowing from abroad § As of 12/31/2011: § U. S. residents owned $21. 1 trillion worth of foreign assets § Foreigners owned $25. 1 trillion worth of U. S. assets § U. S. net indebtedness to rest of the world: $4. 0 trillion—higher than any other country, hence U. S. is the “world’s largest debtor nation” CHAPTER 6 The Open Economy 12

üSince the late 1990 s, the US current account deficits grew until 2006 when it reached over 1. 5% of world GDP. üChina’s current account surplus increased remarkably fast until 2008. üJapan’s surplus also continues to be large and the current account surplus of other East Asian countries are not negligible. CHAPTER 6 The Open Economy 13

ü China has increased its portfolio investment very rapidly. ü East Asian countries’ investment in the US continued to grow. CHAPTER 6 The Open Economy 14

ü Global imbalances of the last decade have been accompanied by massive capital flows from East Asian countries to the US. üEven after the global crisis, East Asian countries’ investment in the US continued to grow. ü China is the biggest investor in the US, followed by Japan. CHAPTER 6 The Open Economy 15

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 CHAPTER 6 The Open Economy 16

National saving: The supply of loanable funds r As in Chapter 3, national saving does not depend on the interest rate S, I CHAPTER 6 The Open Economy 17

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 CHAPTER 6 The Open Economy 18

Investment: The demand for loanable funds r r* Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate… …determines the country’s level of investment. I (r ) I (r* ) CHAPTER 6 The Open Economy S, I 19

If the economy were closed… r …the interest rate would adjust to equate investment and saving: rc I (r ) S, I CHAPTER 6 The Open Economy 20

But in a small open economy… the exogenous world interest rate determines investment… …and the difference between saving and investment determines net capital outflow and net exports CHAPTER 6 r NX r* rc The Open Economy I (r ) I 1 S, I 21

Next, three experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand (exercise) CHAPTER 6 The Open Economy 22

1. Fiscal policy at home r An increase in G or decrease in T reduces saving. NX 2 NX 1 Results: I (r ) I 1 CHAPTER 6 The Open Economy S, I 23

NX and the federal budget deficit (% of GDP), 1965– 2012 10% 2% Budget deficit (left scale) 8% 0% 6% 4% -2% 2% 0% -2% Net exports (right scale) -4% -6% 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. r Results: NX 2 NX 1 I (r ) S, I CHAPTER 6 The Open Economy 25

NOW YOU TRY 3. An increase in investment demand Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. r S NX 1 I (r )1 I 1 S, I 26

ANSWERS 3. An increase in investment demand r S I > 0, S = 0, net capital outflow and NX fall by the amount I NX 2 NX 1 I (r )2 I (r )1 I 2 S, I 27

The nominal exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e. g. yen per dollar) CHAPTER 6 The Open Economy 28

A few exchange rates, as of 5/24/2012 country exchange rate Euro area 0. 79 euro/$ Indonesia 9, 437 rupiahs/$ Japan 79. 6 yen/$ Mexico 14. 0 pesos/$ Russia 31. 79 rubles/$ South Africa 8. 35 rand/$ U. K. 0. 63 pounds/$

Won/US Dollar Exchange Rate CHAPTER 6 The Open Economy Source: Bank of Korea 30 30

The real exchange rate ε = real exchange rate, the lowercase Greek letter epsilon CHAPTER 6 the relative price of domestic goods in terms of foreign goods (e. g. Japanese Big Macs per U. S. Big Mac) The Open Economy 31

Understanding the units of ε ε CHAPTER 6 The Open Economy 32

~ Mc. Zample ~ § one good: Big Mac § price in Japan: § § P* = 200 Yen price in USA: P = $2. 50 nominal exchange rate e = 120 Yen/$ ε CHAPTER 6 The Open Economy To buy a U. S. Big Mac, someone from Japan would have to pay an amount that could buy 1. 5 Japanese Big Macs. 33

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 CHAPTER 6 The Open Economy 34

How NX depends on ε ε U. S. goods become more expensive relative to foreign goods EX, IM NX CHAPTER 6 The Open Economy 35

U. S. net exports and the real exchange rate, 1973– 2012 Trade-weighted real exchange rate index 2% NX (% of GDP) 140 120 100 0% 80 -2% 60 -4% 40 Net exports (left scale) -6% -8% 1970 20 0 1975 1980 1985 1990 1995 2000 2005 2010 Index (March 1973 = 100) 4%

The net exports function § The net exports function reflects this inverse relationship between NX and ε : NX = NX(ε ) CHAPTER 6 The Open Economy 37

The NX curve for the U. S. ε When ε is relatively low, U. S. goods are relatively inexpensive so U. S. net exports will be high ε 1 NX (ε) 0 CHAPTER 6 The Open Economy NX(ε 1) NX 38

The NX curve for the U. S. ε ε 2 At high enough values of ε, U. S. goods become so expensive that we export less than we import NX (ε) NX(ε 2) CHAPTER 6 0 The Open Economy NX 39

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 CHAPTER 6 The Open Economy 40

How ε is determined Neither S nor I depends on ε, so the net capital outflow curve is vertical. ε adjusts to ε ε 1 equate NX with net capital outflow, S - I. CHAPTER 6 The Open Economy NX(ε ) NX 1 NX 41

Interpretation: supply and demand in the foreign exchange market demand: Foreigners need dollars to buy U. S. net exports. ε supply: Net capital outflow (S - I ) is the supply of dollars to be invested abroad. ε 1 CHAPTER 6 The Open Economy NX(ε ) NX 1 NX 42

Next, four experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand (exercise) 4. Trade policy to restrict imports CHAPTER 6 The Open Economy 43

1. Fiscal policy at home A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars in the foreign exchange market… ε ε 2 ε 1 NX(ε ) …causing the real exchange rate to rise and NX to fall. CHAPTER 6 The Open Economy NX 2 NX 1 NX 44

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. CHAPTER 6 ε ε 1 ε 2 The Open Economy NX(ε ) NX 1 NX 2 NX 45

NOW YOU TRY 3. Increase in investment demand Determine the impact of an increase in investment demand on net exports, net capital outflow, and the real exchange rate. ε ε 1 NX(ε ) NX 1 NX 46

ANSWERS 3. Increase in investment demand An increase in investment reduces 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 ε 2 ε 1 NX(ε ) NX 2 NX 1 NX 47

4. Trade policy to restrict imports At any given value of ε, an import quota ε IM NX demand for ε 2 dollars shifts right ε 1 Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remain fixed. CHAPTER 6 The Open Economy NX (ε )2 NX (ε )1 NX 48

4. Trade policy to restrict imports Results: ε > 0 (demand increase) NX = 0 (supply fixed) IM < 0 (policy) EX < 0 (rise in ε ) CHAPTER 6 ε ε 2 ε 1 The Open Economy NX (ε )2 NX (ε )1 NX 49

CHAPTER SUMMARY § Net exports—the difference between § exports and imports § a country’s output (Y ) and its spending (C + I + G) § Net capital outflow equals § purchases of foreign assets minus foreign purchases of the country’s assets § the difference between saving and investment 50

CHAPTER SUMMARY § National income accounts identities § Y = C + I + G + NX § trade balance NX = S – I net capital outflow § Impact of policies on NX § NX increases if policy causes S § to rise or I to fall NX does not change if policy affects neither S nor I. Example: trade policy 51

CHAPTER SUMMARY § Exchange rates § nominal: the price of a country’s currency in terms of another country’s currency § real: the price of a country’s goods in terms of another country’s goods § The real exchange rate equals the nominal rate times the ratio of prices of the two countries. 52

CHAPTER SUMMARY § How the real exchange rate is determined § NX depends negatively on the real exchange rate, other things equal § The real exchange rate adjusts to equate NX with net capital outflow 53