MACROECONOMICS Chapter 5 The Open Economy. 2

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  • MACROECONOMICS Chapter 5 The Open Economy
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  • 2 www.Wikipedia.org
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  • 3 Imports and Exports As a Fraction of GDP Imports and exports as a percentage of GDP by country, 2000. Source: OECD
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  • 4 Trade Balance Capital Flows 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.
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  • 5 US Current Account and Net Foreign Wealth, 19772003
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  • 6 http://www.clevelandfed.org/research/trend s/2009/0909/ET_sep09.pdfhttp://www.clevelandfed.org/research/trend s/2009/0909/ET_sep09.pdf p.9
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  • 8 Why NX is Capital Outflow? You import a DVD of Japanese anime by using your debit card. You import a DVD of Japanese anime by using your debit card. The Japanese producer of anime deposits the funds in its bank account in San Francisco. The bank credits the account by the amount of the deposit. (Capital inflow = -NX) The Japanese producer of anime deposits the funds in its bank account in San Francisco. The bank credits the account by the amount of the deposit. (Capital inflow = -NX) A tourist from Detroit buys a meal in France and pays with a travelers check. (Capital inflow = -NX) A tourist from Detroit buys a meal in France and pays with a travelers check. (Capital inflow = -NX) An Italian buys a Dell computer and pays by a credit card issued by an Italian bank. (Capital outflow = NX) An Italian buys a Dell computer and pays by a credit card issued by an Italian bank. (Capital outflow = NX)
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  • 9 Is US a Small Country? US has the largest GDP in the world with one- fifth of the income, one-seventh of the imports, and one tenth of the exports of the world. US has the largest GDP in the world with one- fifth of the income, one-seventh of the imports, and one tenth of the exports of the world. A large country is one that can affect export or import prices by its supply or demand. Most economists assume that is true of US. A large country is one that can affect export or import prices by its supply or demand. Most economists assume that is true of US. Using an industrial organization approach, Christopher Magee and Stephen Magee (Review of International Economics, 16(5), 990- 1004, 2008) show that US is a small country. Using an industrial organization approach, Christopher Magee and Stephen Magee (Review of International Economics, 16(5), 990- 1004, 2008) show that US is a small country.
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  • 10 Smallness and Capital Flows If capital markets in the world are free then any one can borrow in the world market and any one can lend in the world market. If capital markets in the world are free then any one can borrow in the world market and any one can lend in the world market. If borrowers or lenders (however they are categorized) are small, then the world real interest rate will equate the demand and supply of loanable funds in the world. If borrowers or lenders (however they are categorized) are small, then the world real interest rate will equate the demand and supply of loanable funds in the world. World saving=World investment and r=r* World saving=World investment and r=r*
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  • 11 S, 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 investment plus net exports. Or national saving minus investment equals net exports. This equality shows that national saving will be equal to investment plus net exports. Or national saving minus investment equals net exports. In the classical approach, labor and capital markets are in equilibrium (no unemployment) so the K and L are given in the production function, which makes Y fixed. In the classical approach, labor and capital markets are in equilibrium (no unemployment) so the K and L are given in the production function, which makes Y fixed. Since consumption is determined through Y, once Y is fixed so is C and S HH. Since consumption is determined through Y, once Y is fixed so is C and S HH. If investments are determined by r*, then the difference between S and I will be NX. If investments are determined by r*, then the difference between S and I will be NX.
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  • 12 FIRMS GOVERNMENT FINANCIAL SYSTEM HOUSEHOLDS REST OF THE WORLD Y=wages+salaries+rent+profits+interest C S pri T>TR+INT+G :S gov TTR+INT I NX0 -S for -S gov
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  • 13 S, I, and NX r S r* r** r*** NX>0 NX
  • 18 Determination of +NX S-I=0 0 -NX S-I>0 S-I
  • 19 Policies and Expansionary fiscal policy at home Expansionary fiscal policy at home S down => r up => up => NX down S down => r up => up => NX down Expansionary fiscal policy abroad Expansionary fiscal policy abroad World savings down => r* up => S-I up => down => NX up World savings down => r* up => S-I up => down => NX up Investment tax credit at home Investment tax credit at home I up => r up => up => NX down I up => r up => up => NX down Protectionist policies Protectionist policies NX shifts right (more NX at same ) => up but no change in NX because S-I did not change NX shifts right (more NX at same ) => up but no change in NX because S-I did not change
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  • 20 Nominal Exchange and Inflation Nominal exchange rate times price ratios equal real exchange rate. Nominal exchange rate equals real exchange rate times price ratios (observe which countrys 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.
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  • 21 Law of One Price Tradable goods should have the same price because of arbitrage. Tradable goods should have the same price because of arbitrage. Apply the same principle and you get real exchange rate of one. Apply the same principle and you get real exchange rate of one. Not even Big Macs follow the law of one price. Not even Big Macs follow the law of one price.
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  • 22 http://www.economist.c om/markets/indicators/ displaystory.cfm?story_i d=13055650 2009