6. The Open Economy - go.owu.edu

National Income & Business Cycles Ohio Wesleyan University Goran Skosples 6. The Open Economy 1 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 2 Key Concepts

Net exports Trade balance Capital mobility Net capital outflow Small open economy World interest rate Nominal exchange rate Real exchange rate Purchasing power parity Trade policy Large open economy 3 Imports and exports of selected countries, 2017 Percent of GDP

50 Exports 45 40 35 30 25 20 15 10 5 0 Australia China Germany Canada Korea, Rep. MexicoUnited States 4 In an open economy,

spending need not equal _______ saving need not equal ___________ EX = exports = foreign spending on domestic goods IM = imports = domestic spending on foreign goods NX = net exports (a.k.a. the trade balance) = EX IM 5 The national income identity in an open economy Y = C + I + G + NX or, NX = Y (C + I + G ) net exports trade surplus: output __ spending and EX __ IM trade deficit: spending __ output and IM __ EX 6

International capital flows Net capital outflow =S I = net outflow of loanable funds = net purchases of foreign assets the countrys purchases of foreign assets minus foreign purchases of domestic assets When S > I, country is a _________ When S < I, country is a ____________ 7 The link between trade & cap. flows NX = Y (C + I + G ) implies NX = = = Thus,

Thus, aa country country with with aa trade trade deficit deficit (NX (NX << 0) 0) is is aa net net ____________ ____________ (S (S <

15% 10% 20% 5% 15% 0% 10% 5% 0% -5% T r a d e B a la n c e ( % o f G D P ) I n v e s t m e n t , S a v in g ( % o f G Saving, investment, and the trade balance 19602018

-10% 9 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 Y Y F (K , L) consumption function investment function C C (Y T ) I I (r ) exogenous policy variables G G , T T 10 National saving:

The supply of loanable funds r As As in in Chapter Chapter 3, 3, national national saving saving ____ ____ ____depend ____depend on on the the interest interest rate rate S, I 11 Assumptions re: Capital flows

a. domestic & foreign bonds are perfect ________ (same risk, maturity, etc.) b. perfect capital _________: no restrictions on international trade in assets c. economy is ______: cannot affect the world interest rate, denoted r* aa && bb imply imply _____ _____ cc implies implies r* r* is is __________ __________ 12 Investment: The demand for loanable funds r

Investment is still a _________-sloping function of the interest rate, but the exogenous world interest rate determines the countrys level of ___________. S, I 13 If the economy were closed r S I (r ) S, I 14 Point Trade balance is determined by saving and

investment at the world interest rate. r r S S r* I (r ) S, I when S I the country ____ K ___ the rest of the world r* I (r ) S, I

when S __ I the country ______ K ____ the rest of the world 15 Three experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 16 1. Fiscal policy at home r An An increase increase in in G G or or decrease decrease in in TT

_______ _______ saving. saving. S1 Results: I 0 NX S 0 I (r ) S, I 17 NX and the federal budget deficit (% of GDP), 19652013 10% 2% Budget deficit (left scale)

8% 0% 6% 4% -2% 2% 0% -2% -4% Net exports (right scale) -4% 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 -6% 18

2. Fiscal policy abroad Expansionary fiscal policy abroad _____ the world interest rate. r S1 NX * 1 r 1 Results: Results: I 0

I (r ) NX I 0 I (r1* ) S, I 19 3. 3. An An increase increase in in investment investment demand demand r ANSWERS: ANSWERS: I ,, I S ,,

S net net capital capital outflow outflow and and NX NX ________ ________ ___________ ___________ ___________ ___________ S r* NX 1 I (r )1 I1

S, I 20 Two exchange rates e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar) = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac) 21 Understanding the units of e P P* (Yen per $) ($ per unit U.S. goods)

Yen per unit Japanese goods Yen per unit U.S. goods Yen per unit Japanese goods Units of Japanese goods per unit of U.S. goods 22 ~ McZample ~ one good: Big Mac price in Japan: P* = 200 Yen price in USA: P = $2.50 nominal exchange rate e = 120 Yen/$ To Tobuy

buyaaU.S. U.S.Big BigMac, Mac, someone someonefrom fromJapan Japan would wouldhave haveto topay payan an amount amountthat thatcould couldbuy buy __ __Japanese JapaneseBig BigMacs. Macs.

23 How NX depends on U.S. goods become more expensive relative to foreign goods EX, NX IM The net exports function The net exports function reflects this inverse relationship between NX and : NX = 24 U.S. net exports and the real exchange

rate, 19732012 NX (% of GDP) 2% 140 Trade-weighted real exchange rate index 0% 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 120 100 80 -2% 60 -4% -6% -8%

40 Net exports (left scale) Index (March 1973 = 100) 4% 20 0 25 The NX curve for the U.S. 0 NX ( ) N X 26

How 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, must adjust to ensure 27 How is determined Neither Neither S S nor nor II depend depend on on ,, so so the the net

net capital capital outflow outflow curve curve is is _____. _____. 1 adjusts adjusts to to ________ ________ NX NX with with net net capital capital

outflow, outflow, _____. _____. NX( ) NX 28 Four experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports 29 1. Fiscal policy at home G

S1 I (r *) 1 NX 1 NX( ) NX 30 2. Fiscal policy abroad G abroad

S1 I (r1*) 1 NX 1 NX( ) NX 31 3. 3. Increase Increase in in investment

investment demand demand I S1 I 1 1 NX 1 NX( ) NX

32 4. Trade policy to restrict imports At At any any given given value value of of , , an an import import quota quota NX IM IM NX demand

demand for for dollars dollars _____ _____ ______ 1 ______ Trade Trade policy policy ______ ______ affect affect SS or or II ,, so so capital capital flows flows and and the the supply supply of of dollars

dollars ____________. ____________. S I NX ( )1 NX1 NX 33 The determinants of the nominal exchange rate Start with the expression for the real exchange rate: e P * P Solve for the nominal exchange rate:

34 The determinants of the nominal exchange rate So e depends on the real exchange rate and the price levels at home and abroad and we know how each of them is determined: P* e P 35 The determinants of the nominal exchange rate P* e P Rewrite this equation in growth rates (recall arithmetic tricks for working with % changes)

For a given value of , the growth rate of e equals the difference between ____________________________. 36 Inflation differentials and nominal exchange rates for a cross section of countries % change in nominal exchange rate 8% Iceland 6% Pakistan 4% Mexico 2%

-4% S. Korea Sweden 0% -2% S. Africa U.K. Japan Denmark Canada Singapore Switzerland -6% -4%

-2% Australia New Zealand 0% 2% 4% 6% 8% inflation differential37 Purchasing Power Parity (PPP) If international arbitrage is possible, then $ must have the same purchasing power in every country __ equalizes purchasing power: Does PPP hold in the real world? No entirely, for two reasons:

1. International arbitrage not possible. 2. Goods of different countries not __________ ________________. Why is PPP then important? 38 CASE STUDY: The Reagan deficits revisited actual 1970s 1980s change GT 2.2 3.9 S

19.6 17.4 r 1.1 6.3 I 19.9 19.4 NX

-0.3 -2.0 115.1 129.4 closed economy small open economy Data: decade averages; all except r and are expressed as a percent of GDP; is a trade-weighted index. 39

The U.S. as a large open economy So far, weve learned long-run models for two extreme cases: closed economy (chap. 3) small open economy (chap. 5) A large open economy like the U.S. falls ___________ these two extremes. The results from large open economy analysis are a ___________ of the results for the closed & small open economy cases. For example 40 A fiscal expansion in three models A fiscal expansion causes national saving to fall. The effects of this depend on openness & size: closed economy large open

economy small open economy r I NX 41 Summary 1. Net exports--the difference between exports and imports a countrys output (Y ) and its spending (C + I + G) 2. Net capital outflow equals purchases of foreign assets minus foreign purchases of the countrys assets the difference between saving and investment 3. National income accounts identities:

Y = C + I + G + NX trade balance NX = S - I net capital outflow 42 Summary 4. 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 5. Exchange rates nominal: the price of a countrys currency in terms of another countrys currency real: the price of a countrys goods in terms of another countrys goods. the real exchange rate equals the nominal rate times the ratio of prices of the two countries.

43 Summary 7. 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 44

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