Lecture 1b. The open economy. - UAM · Lecture 1b. The open economy. ... Mankiw,2009 andBlanchard,2007 books. Iam grateful for that. 1 Carlos Llano (P) & Nuria Gallego (TA) Learning

Lecture 1b. The open economy. The international flows of capital and goods, balance of payments and exchange rates.

References: these slides have been developed based on the ones provided byBeatriz de Blas and Julián Moral (UAM), as well as the official materials fromMankiw, 2009 and Blanchard, 2007 books. I am grateful for that.

1

Carlos Llano (P)& Nuria Gallego (TA)

Learning objectives

• A model for 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

Outline

1. The international flows of goods2. The international flows of capital3. Exchange rate determination:

1. Net balance2. Purchase Power Parity

3

0. PRELIMINARIES

4

How NX depends on ε

ε U.S. goods become more expensive relative to foreign goods

EX, IM

NX

5

Sterling’s Real Exchange Rate andTrade Deficit of the UK: 1980‐2005

90

100

110

120

130

140

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Rea

l Effe

ctiv

e Ex

chan

ge R

ate

(avr

g.

2000

=100

)

-6

-5

-4

-3

-2

-1

0

1

2

3

Net Exports (%

of GD

P)

depreciationappreciation

6

The net exports function

• The net exports function reflects this inverse relationship between NX and ε :

NX = NX(ε)

7

The NX curve

0 NX

ε

NX(ε)

ε1

When ε is relatively low, home goods are relatively inexpensive

NX(ε1)

so net exports will be high

8

The NX curve

0 NX

ε

NX(ε)

ε2

At high enough values of ε, home goods become so expensive that

NX(ε2)

we export less than we import

9

Dynamic analysis: the J curve

Depreciation of your local currency

0

Net

Exp

orts

, NX

Time

CA

B

0

_

+

U.S. Net Exports and the Real Exchange Rate: 1980‐2005

80

90

100

110

120

130

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Rea

l Effe

ctiv

e Ex

chan

ge R

ate

(avr

g. 2

000=

100)

-6

-5

-4

-3

-2

-1

0

Net Exports (%

of GD

P)

depreciation

appreciation

11

1. THE INTERNATIONAL FLOWS OF GOODS

12

1. The international flows of goods

• In an open economy (domestic) spending need not equal output

(domestic) savings need not equal investment

13

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 goodsf = spending on

foreign goods

14

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

15

GDP identity in an open economy

• New GDP identity for open economy

• Examples of why the new accounting entries are necessary to make the equality hold:– An imported Toyota truck is counted in C but not in GDP; the negative entry in IM cancels out the positive entry under C

– Exported Ford truck is counted in GDP but not in C, I or G domestically; the positive entry in EX provides a way to account for it on the right‐hand side of the equation.

Y C I G NX

16

The national income identity in an open economy

Y = C + I + G + NX

or, NX = Y – (C + I + G )

net exports

domestic spending

output

17

Trade surpluses and deficits

• trade surplus:If output > spending; exports > imports. Size of the trade surplus = NX

• trade deficit:If spending > output; imports > exports Size of the trade deficit = –NX

NX = X – IM = Y – (C + I + G )

18

We subtract C + T from both sides of the equation:

S = I + G ‐ T – IM/ε + X

Using the expression: NX X – IM/ε

Y = C + I + G – IM/ε + X ; S = Y ‐ C ‐ T

NX = S + (T ‐ G) ‐ I

Trade

balance

National

SavingsInvestments= ‐

Trade surpluses and deficits

U.S. net exports, 1950‐2006

U.S. Net Exports, 1950-2006

-800

-600

-400

-200

0

200

1950 1960 1970 1980 1990 2000

billi

ons

of d

olla

rs

-8%

-6%

-4%

-2%

0%

2%

perc

ent o

f GD

P

NX ($ billions) NX (% of GDP)

20

2. THE INTERNATIONAL FLOWS OF CAPITAL

21

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 borrower22

The link between trade & cap. flows

NX = Y – (C + I + G )implies

NX = (Y – C – G ) – I= S – Itrade balance = net capital outflow

Thus, a country with a trade deficit (NX < 0)

is a net borrower (S <I ).

Thus, a country with a trade deficit (NX < 0)

is a net borrower (S <I ).

23

Saving and Investment in a Small Open Economy

• An open‐economy version of the loanable funds model.

• Includes many of the same elements:

production function: ( , )Y Y F K L

consumption function: ( )C C Y T

investment function: ( )I I r

exogenous policy variables: ,G G T T

+TR-T)

24

National Saving: The Supply of Loanable Funds

r

S, I

National saving does not depend on the interest rate

( )S Y C Y T G

S

+TR-T)-G

25

Assumptions re: 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

a & b imply r = r*

c implies r* is exogenous

26

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 )

27

If the economy were closed…

r

S, I

I (r )

S

rc

( )cI rS

…the interest rate would adjust to equate investment and saving:

28

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 outflows and net exports

NX

29

Three thought experiments

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

30


r

S, I

I (r )

1S

I 1

An increase in G,TR or decrease in Treduces saving.

1*r

NX1

2S

NX2

Results: 0I

0NX S

31

NX and Government Budgets in the U.S.: 1974‐2005

-6

-5

-4

-3

-2

-1

0

1

2

3

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Gov

ernm

ent B

udge

t Sur

plus

(%

of G

DP)

-6

-5

-4

-3

-2

-1

0

1

2

3

Net Exports (%

of GD

P)

32

NX and Government Budgets in the U.S.: 1974‐2005

33


r

S, I

I (r )

1SExpansionary fiscal policy abroad raises the world interest rate. 1

*rNX1

NX2

Results: 0I

0NX I

2*r

1( )*I r2( )*I r

34


r

S, I

I (r )1

EXERCISE:Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.

NX1

*r

I 1

S

35

r

S, I

I (r )1

ANSWERS:I > 0,S = 0,net capital outflows and net exports fall by the amount I

NX2

NX1

*r

I 1 I 2

S

I (r )2


36

3. EXCHANGE RATE DETERMINATION:3.1. NET BALANCE

37

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*)

38

How ε is determined

Neither S nor Idepend on ε, so the net capital outflow curve is vertical.

Neither S nor Idepend 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.

ε adjusts to equate NXwith net capital outflow, S I.

ε 1

NX1

39

Interpretation: Supply and demand in the foreign exchange market

demand: NXForeigners need “your local currency” in order to buy your products (exports).

demand: NXForeigners need “your local currency” in order to buy your products (exports).

ε

NX

NX(ε )

1 ( *)S I r

supply: S‐INet capital outflow (S I ) is the supply of dollars (local currency) to be invested abroad.

supply: S‐INet capital outflow (S I ) is the supply of dollars (local currency) to be invested abroad.

ε 1

NX 1

40

Next, four experiments:




4. Trade policy to restrict imports

41


A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars (local currency in the U.S.) in the foreign exchange market…

A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars (local currency in the U.S.) 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

42


An increase in r*reduces investment, increasing net capital outflow and the supply of dollars in the foreign exchange market…

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.

…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

43

3. Increase in investment demand

An increase in investment reduces net capital outflow and the supply of dollars (local currency in U.S.) in the foreign exchange market…

An increase in investment reduces net capital outflow and the supply of dollars (local currency in U.S.) in the foreign exchange market…

ε

NX

NX(ε )…causing the real exchange rate to rise and NX to fall.


ε1

1 1S I

NX1

21S I

NX2

ε2

44


At any given value of ε, an import quota IM NX demand for

dollars shifts right

At any given value of ε, an import quota IM NX demand for

dollars shifts right

ε

NX

NX (ε )1

S I

NX1

ε1

NX (ε )2Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remain fixed.

Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remain fixed.

ε2

45


ε

NX

NX (ε )1

S I

NX1

ε1

NX (ε )2

Results:ε > 0 (demand increase)

NX = 0(supply fixed)

IM < 0 (policy)

EX < 0(rise in ε )

Results:ε > 0 (demand increase)

NX = 0(supply fixed)

IM < 0 (policy)

EX < 0(rise in ε )

ε2

46

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:

e P *

P

47


• 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:

( * , )M L r YP

e P *

P

** *

* ( * *, )M L r YP

NX() = S - I(r*)

48


• Rewrite this equation in growth rates

ee

P *

P *PP

*

For a given value of , the growth rate of e equals the difference between foreign and domestic inflation rates.

e P *

P

49

Inflation differentials and nominal exchange rates

Percentage changein nominalexchange rate

10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4

Inflation differential

Depreciationrelative to U.S. dollar

Appreciationrelative to U.S. dollar

-1-2-3 10 2 3 4 5 6 87

France

Canada

SwedenAustralia

UK

IrelandSpain

South Africa

Italy

New Zealand

NetherlandsGermany

Japan

Belgium

Switzerland

50

3.2. PURCHASE POWER PARITY (PPP)

51

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.

52

Purchasing Power Parity (PPP)

• If e = P*/P, then e

PP *

P *

P

PP *

1

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.

Under PPP, changes in (S – I ) have no impact on ε or e.

53

NX

I

r

large open economy

small open economy

closedeconomy

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:

January 201254

Lecture 1b. The open economy. - UAM · Lecture 1b. The open economy. ... Mankiw,2009 andBlanchard,2007 books. Iam grateful for that. 1 Carlos Llano (P) & Nuria Gallego (TA) Learning

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