MACROECONOMICSMACROECONOMICS

Chapter 5Chapter 5

The Open EconomyThe Open Economy

22

www.Wikipedia.org

33

Imports and Exports Imports and Exports As a Fraction of GDPAs a Fraction of GDP

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Canada France Germany Italy Japan Mexico UK US

Per

cen

tag

e o

f G

DP

imports exports

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Canada France Germany Italy Japan Mexico UK US

Per

cen

tag

e o

f G

DP

imports exports

Imports and exports as a percentage of GDP by country, 2000. Source: OECD

44

Trade Balance Trade Balance ≈ Capital Flows≈ Capital Flows

NXSI

NXIS

NXISS

NXISGT

NXGIST

STCY

NXGICY

HHGOV

HH

HH

HH

A positive trade balance (trade surplus) happens when national saving exceeds investments. A trade deficit indicates that investments are greater than national savings.

A trade surplus means there is a capital outflow. A trade deficit means there is a capital inflow.

If domestic spending (C+I+G) is less than the GDP (Y), then net exports will be positive. If domestic spending exceeds Y then there will be a trade deficit.

55

US Current Account and US Current Account and Net Foreign Wealth, 1977–2003Net Foreign Wealth, 1977–2003

66

http://www.clevelandfed.org/research/trends/2009/0909/ET_sep09.pdf p.9

77

88

Why NX is Capital Outflow?Why NX is Capital Outflow?

You import a DVD of Japanese anime by You import a DVD of Japanese anime by using your debit card. using your debit card. The Japanese producer of anime deposits the The Japanese producer of anime deposits the

funds in its bank account in San Francisco. The funds in its bank account in San Francisco. The bank credits the account by the amount of the bank credits the account by the amount of the deposit. (Capital inflow = -NX)deposit. (Capital inflow = -NX)

A tourist from Detroit buys a meal in France and A tourist from Detroit buys a meal in France and pays with a traveler’s check. (Capital inflow = -NX)pays with a traveler’s check. (Capital inflow = -NX)

An Italian buys a Dell computer and pays by a An Italian buys a Dell computer and pays by a credit card issued by an Italian bank. (Capital credit card issued by an Italian bank. (Capital outflow = NX)outflow = NX)

99

Is US a Small Country?Is US a Small Country?

US has the largest GDP in the world with one-US has the largest GDP in the world with one-fifth of the income, one-seventh of the imports, fifth of the income, one-seventh of the imports, and one tenth of the exports of the world.and one tenth of the exports of the world.

A large country is one that can affect export or A large country is one that can affect export or import prices by its supply or demand. Most import prices by its supply or demand. Most economists assume that is true of US.economists assume that is true of US.

Using an industrial organization approach, Using an industrial organization approach, Christopher Magee and Stephen Magee Christopher Magee and Stephen Magee ((Review of International Economics, 16(5), 990-Review of International Economics, 16(5), 990-1004, 2008) 1004, 2008) show that US is a small country.show that US is a small country.

1010

Smallness and Capital FlowsSmallness and Capital Flows

If capital markets in the world are free then If capital markets in the world are free then any one can borrow in the world market any one can borrow in the world market and any one can lend in the world market.and any one can lend in the world market.

If borrowers or lenders (however they are If borrowers or lenders (however they are categorized) are small, then the world real categorized) are small, then the world real interest rate will equate the demand and interest rate will equate the demand and supply of loanable funds in the world.supply of loanable funds in the world.

World saving=World investment and r=r*World saving=World investment and r=r*

1111

S, I, NX in Small Open EconomiesS, I, NX in Small Open Economies

Circular flow makes GDP=Income.Circular flow makes GDP=Income. This equality shows that national saving will be equal to This equality shows that national saving will be equal to

investment plus net exports. Or national saving minus investment plus net exports. Or national saving minus investment equals net exports.investment equals net exports.

In the classical approach, labor and capital markets are In the classical approach, labor and capital markets are in equilibrium (no unemployment) so the K and L are in equilibrium (no unemployment) so the K and L are given in the production function, which makes Y fixed.given in the production function, which makes Y fixed.

Since consumption is determined through Y, once Y is Since consumption is determined through Y, once Y is fixed so is C and Sfixed so is C and SHHHH..

If investments are determined by r*, then the difference If investments are determined by r*, then the difference between S and I will be NX.between S and I will be NX.

1212

FIRMS

GOVERNMENT

FINANCIAL SYSTEM

HOUSEHOLDS

REST OF THE WORLD

Y=wages+salaries+rent+profits+interest

C

Spri

T>TR+INT+G :Sgov

T TR+INTI

NX<0 Sfor

EX IM

G

GDP

NX>0 -Sfor

-Sgov

1313

S, I, and NXS, I, and NXr

S

r*

r**

r***NX>0

NX<0

NX=0

S-I=NX gets different values for different real interest rate for the world. At r** the interest rate would be the same as the closed economy interest rate.

I,S

What would happen to this diagram (1) when expansionary fiscal policy is pursued? (2) when new savings enter the world capital markets? (3) when investment at home increases? (4) when world investment increases?

I

1414

Is Trade Deficit Bad?Is Trade Deficit Bad?

If it is the result of low national savings, If it is the result of low national savings, then the future generations will have to then the future generations will have to pay in lower consumption.pay in lower consumption.

If it is the result of high investment, future If it is the result of high investment, future income will be higher to compensate for income will be higher to compensate for the interest on the debt.the interest on the debt.

1515

Why Doesn’t Capital Flow to Why Doesn’t Capital Flow to Poor Countries?Poor Countries?

MPK is higher when K is lower.MPK is higher when K is lower.But poor countries might have other But poor countries might have other

limitations reducing A, hence lowering Y.limitations reducing A, hence lowering Y. InfrastructureInfrastructureCourt systemCourt systemCorruptionCorruptionUndefined, unreliable property rightsUndefined, unreliable property rights

1616

Exchange RateExchange Rate

Nominal Exchange Rate Nominal Exchange Rate ¥/$ or $/€¥/$ or $/€Real Exchange Rate Real Exchange Rate

(¥/$)(P(¥/$)(PUSUS/P/PJJ) ) εε = e (P/P*) = e (P/P*) ($/€)(P($/€)(PEUEU/P/PUSUS))

Suppose 100 ¥=1$, 2$=1€, an average Suppose 100 ¥=1$, 2$=1€, an average American car is $20,000, Japanese car is American car is $20,000, Japanese car is ¥1,000,000, German car is €15,000. ¥1,000,000, German car is €15,000.

The meaning of Real Exchange Rate in The meaning of Real Exchange Rate in terms of cars; in general.terms of cars; in general.

1717

NX and NX and εε

When the real exchange rate (When the real exchange rate (εε) is high ) is high domestic goods are more expensive domestic goods are more expensive compared to foreign goods. NX goes compared to foreign goods. NX goes down. down.

NX = NX (NX = NX (εε)) εε = = (EUR/USD)(Pus/Peu)(EUR/USD)(Pus/Peu)

ε

NX0

1818

Determination of Determination of εε

ε

+NX

S-I=0

0-NX

S-I>0S-I<0

NX(ε)

1919

Policies and Policies and εε Expansionary fiscal policy at homeExpansionary fiscal policy at home

S down => r up => S down => r up => εε up => NX down up => NX down

Expansionary fiscal policy abroadExpansionary fiscal policy abroad World savings down => r* up => S-I up => World savings down => r* up => S-I up => εε down => down =>

NX upNX up

Investment tax credit at homeInvestment tax credit at home I up => r up => I up => r up => εε up => NX down up => NX down

Protectionist policiesProtectionist policies NX shifts right (more NX at same NX shifts right (more NX at same εε) => ) => εε up but no up but no

change in NX because S-I did not changechange in NX because S-I did not change

2020

Nominal Exchange and InflationNominal Exchange and Inflation

EU

US

P

P

USD

EUR

*P

Pe

Nominal exchange rate times price ratios equal real exchange rate.

P

Pe

*

Nominal exchange rate equals real exchange rate times price ratios (observe which country’s price level is in the numerator and which in the denominator).

Percentage change in nominal exchange rate equals percentage change in the real exchange rate + percentage change in the abroad price level – percentage change in the home price level.

Ceteris paribus, if inflation at home is larger than abroad, then the nominal exchange rate should depreciate. If abroad inflation is higher than home, nominal exchange rate should appreciate.

2121

Law of One PriceLaw of One Price

Tradable goods should have the same Tradable goods should have the same price because of arbitrage.price because of arbitrage.

Apply the same principle and you get real Apply the same principle and you get real exchange rate of one.exchange rate of one.

Not even Big Macs follow the law of one Not even Big Macs follow the law of one price.price.

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http://www.economist.com/markets/indicators/displaystory.cfm?story_id=13055650

2009