© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
A Macroeconomic Theory
of the Open Economy Premium PowerPoint
Slides by Ron Cronovich
N. Gregory Mankiw
Economics Principles of
Sixth Edition
32
1 1
In this chapter,
look for the answers to these questions:
• In an open economy, what determines the real
interest rate? The real exchange rate?
• How are the markets for loanable funds and
foreign-currency exchange connected?
• How do government budget deficits affect the
exchange rate and trade balance?
• How do other policies or events affect the
interest rate, exchange rate, and trade balance?
2 2
Introduction
The previous chapter explained the basic
concepts and vocabulary of the open economy:
net exports (NX), net capital outflow (NCO),
and exchange rates.
This chapter ties these concepts together into a
theory of the open economy.
We will use this theory to see how govt policies
and various events affect the trade balance,
exchange rate, and capital flows.
We start with the loanable funds market…
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3 3
The Market for Loanable Funds
An identity from the preceding chapter:
S = I + NCO
Saving Domestic
investment
Net capital
outflow
Supply of loanable funds =
A dollar of saving can be used to finance
So, demand for loanable funds =
4 4
The Market for Loanable Funds
Recall:
S depends positively on the real interest rate, r.
I depends negatively on r.
What about NCO?
5 5
How NCO Depends on the Real Interest Rate
The real interest rate, r,
is the real return on
domestic assets.
A fall in r
r
NCO
NCO
Net capital outflow
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
6 6
The Loanable Funds Market Diagram
r
LF
S = saving
Loanable funds
A C T I V E L E A R N I N G 1
Budget deficits and capital flows
Suppose the government runs a budget deficit
(previously, the budget was balanced).
Use the appropriate diagrams to determine
the effects on the real interest rate and
net capital outflow.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
A C T I V E L E A R N I N G 1
Answers
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9 9
The Market for Foreign-Currency Exchange
Another identity from the preceding chapter:
NCO = NX
Net exports Net capital
outflow
In the market for foreign-currency exchange,
10 10
The Market for Foreign-Currency Exchange
Recall:
The U.S. real exchange rate (E) measures
the quantity of foreign goods & services
that trade for one unit of U.S. goods & services.
E is the real value of a dollar in the market for
foreign-currency exchange.
11 11
The Market for Foreign-Currency Exchange
An increase in E makes
U.S. goods more
expensive to foreigners,
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
12 12
FYI: Disentangling Supply and Demand
When a U.S. resident buys imported goods,
does the transaction affect supply or demand
in the foreign exchange market? Two views:
1.
The person needs to sell her dollars to obtain the
foreign currency she needs to buy the imports.
2.
The increase in imports reduces NX,
which we think of as the demand for dollars.
(So, NX is really the net demand for dollars.)
Both views are equivalent. For our purposes,
it’s more convenient to use the second.
13 13
FYI: Disentangling Supply and Demand
When a foreigner buys a U.S. asset,
does the transaction affect supply or demand
in the foreign exchange market? Two views:
1.
The foreigner needs dollars in order to purchase
the U.S. asset.
2.
The transaction reduces NCO, which we think of
as the supply of dollars.
(So, NCO is really the net supply of dollars.)
Again, both views are equivalent. We will use the
second.
A C T I V E L E A R N I N G 2
Budget deficit, exchange rate, and NX
Initially, the government budget is balanced and
trade is balanced (NX = 0).
Suppose the government runs a budget deficit.
As we saw earlier, r rises and NCO falls.
How does the budget deficit affect the U.S. real
exchange rate? The balance of trade?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
A C T I V E L E A R N I N G 2
Answers
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The “Twin
Deficits”
Net exports and the budget deficit
often move in opposite directions.
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
19
61-6
5
19
66-7
0
19
71-7
5
19
76-8
0
19
81-8
5
19
86-9
0
19
91-9
5
19
96-2
000
20
01-2
005
20
06-2
010
Pe
rcen
t o
f G
DP
U.S. federal
budget deficit
U.S. net exports
17 17
SUMMARY: The Effects of a Budget Deficit
National saving falls
The real interest rate rises
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
18 18
SUMMARY: The Effects of a Budget Deficit
One other effect:
Due to many years of budget and trade deficits,
International Investment Position of the U.S.
31 December 2009
Value of U.S.-owned foreign assets $18.4 trillion
Value of foreign-owned U.S. assets $21.1 trillion
U.S.’ net debt to the rest of the world $2.7 trillion
The Connection Between Interest Rates and Exchange Rates
r
NCO
E
dollars
NCO
D = NX
S1 = NCO1
E1
r1
Anything that
increases r NCO1
NCO1
A C T I V E L E A R N I N G 3
Investment incentives
Suppose the government provides new
tax incentives to encourage investment.
Use the appropriate diagrams to determine how
this policy would affect:
the real interest rate
net capital outflow
the real exchange rate
net exports
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
A C T I V E L E A R N I N G 3
Answers
23 23
Budget Deficit vs. Investment Incentives
A tax incentive for investment has similar effects
as a budget deficit:
But one important difference:
Investment tax incentive
Budget deficit
24 24
Trade Policy
Trade policy:
Examples:
Tariff
Import quota
“Voluntary export restrictions”
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
25 25
Trade Policy
Common reasons for policies that restrict imports:
Do such trade policies accomplish these goals?
Let’s use our model to analyze the effects of
an import quota on cars from Japan
designed to save jobs in the U.S. auto industry.
26 26
D
An import quota
Analysis of a Quota on Cars from Japan
r
NCO
NCO
Net capital outflow r
LF
S
Loanable funds
r1 r1
27 27
Analysis of a Quota on Cars from Japan
S = NCO E
Dollars
D1
E1
Market for foreign-
currency exchange
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
28 28
Analysis of a Quota on Cars from Japan
What happens to NX?
If E could remain at E1, NX would rise, and the
quantity of dollars demanded would rise.
But the import quota does not affect NCO,
so
Since NX must equal NCO,
Hence, the policy of restricting imports
29 29
Analysis of a Quota on Cars from Japan
Does the policy save jobs?
The quota reduces imports of Japanese autos.
But
30 30
CASE STUDY: Capital Flows from China
In recent years, China has accumulated U.S. assets
to reduce its exchange rate and boost its exports.
Results in U.S.:
Some U.S. politicians want China to stop,
argue for restricting trade with China to protect
some U.S. industries.
Yet, U.S. consumers benefit, and the net effect of
China’s currency intervention is probably small.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
31 31
Political Instability and Capital Flight
People worried about the safety of Mexican
assets they owned.
People sold many of these assets, pulled their
capital out of Mexico.
Capital flight:
We analyze this using our model, but from the
perspective of Mexico, not the U.S.
32 32
D1
Capital Flight from Mexico
r
NCO
NCO1
r1
Net capital outflow r
LF
S1
r1
Loanable funds
33 33
Capital Flight from Mexico
Market for foreign-
currency exchange
E
Pesos
D1
S1 = NCO1
E1
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Examples of Capital Flight: Mexico, 1994
0.10
0.15
0.20
0.25
0.30
0.35
10/2
3/1
994
11/1
2/1
994
12/2
/1994
12/2
2/1
994
1/1
1/1
995
1/3
1/1
995
2/2
0/1
995
3/1
2/1
995
4/1
/1995
US
Do
llars
per
cu
rren
cy u
nit
.
Examples of Capital Flight: S.E. Asia, 1997
0
20
40
60
80
100
120
12
/1/1
99
6
2/2
4/1
99
7
5/2
0/1
99
7
8/1
3/1
99
7
11
/6/1
99
7
1/3
0/1
99
8
4/2
5/1
99
8
7/1
9/1
99
8
US
Do
llars
per
cu
rren
cy u
nit
.1
/1/1
99
7 =
10
0
South Korea Won
Thai Baht
Indonesia Rupiah
Examples of Capital Flight: Russia, 1998
0.00
0.04
0.08
0.12
0.16
0.20
5/5
/1998
6/1
4/1
998
7/2
4/1
998
9/2
/1998
10/1
2/1
998
11/2
1/1
998
12/3
1/1
998
US
Do
llars
per
cu
rren
cy u
nit
.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Examples of Capital Flight: Argentina, 2002
0.0
0.2
0.4
0.6
0.8
1.0
1.2
7/1
/20
01
9/1
9/2
00
1
12
/8/2
00
1
2/2
6/2
00
2
5/1
7/2
00
2
8/5
/20
02
10
/24
/20
02
1/1
2/2
00
3
U.S
. D
ollars
per
cu
rren
cy u
nit
.
38 38
CONCLUSION
The U.S. economy is becoming increasingly
open:
Trade in g&s is rising relative to GDP.
Increasingly, people hold international assets in
their portfolios and firms finance investment
with foreign capital.
39 39
CONCLUSION
Yet, we should be careful not to blame our
problems on the international economy.
When politicians and commentators
discuss international trade and finance,
the lessons of this and the preceding chapter
can help separate myth from reality.