MACROECONOMICS Seventh Edition N. Gregory · PDF fileMACROECONOMICS Seventh Edition N. Gregory Mankiw ... ( e.g. Japanese Big Macs per U.S. Big Mac, that is, ... Supply and Demand

Chapter 5: The Open Economy*

MACROECONOMICS

Seventh Edition

N. Gregory Mankiw

Chapter 5: The Open Economy 0/59*Slides based on Ron Cronovich's slides, adjusted for course in Macroeconomics at the Wang Yanan Institute for Studies in Economics at Xiamen University.

Imports and exports (% of GDP), 2007

60

Exports

20

30

40

50

Per

cen

t o

f G

DP

ExportsImports

Chapter 5: The Open Economy 1/59

0

10

Australia China Germany Greece S. Korea Mexico United States

Per

cen

t o

f G

DP

Learning Objectives

This chapter introduces you to understanding:This chapter introduces you to understanding:

the international flows of capital and goods

saving and investment in a small open economy

Exchange rates


Exchange rates

the U.S. As a large open economy

5.1) The International Flows of C & G

In an international economyIn an international economy

� spending need not equal output

� saving need not equal investment


d fC C C= + superscripts:

d = spending on domestic goods


� Preliminaries

EX = exports = foreign spending on domestic goods

IM = imports = C f + I f + G f

d fI I I= +

d fG G G= +

d = spending on domestic goodsf = spending on foreign goods


IM = imports = C + I + G = spending on foreign goods

NX = net exports (a.k.a. the “trade balance”) = EX – IM

d d dY C I G EX= + + +


� GDP=Expenditure on Dom. Produced G & S

( ) ( ) ( )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 EX IM= + + + −

C I G NX= + + +

Y = C + I + G + NX


� The Open Economy National Income Identity

or, NX = Y – (C + I + G )

domestic spending


net exports spending

output

NX = EX – IM = Y – (C + I + G )


� Trade Surpluses and Deficits

� Trade surplus:output > spending and exports > imports Size of the trade surplus = NX

� Trade deficit:spending > output and imports > exports


spending > output and imports > exports Size of the trade deficit = –NX

� Net capital outflow


� International Capital Flows

= 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 borrower

NX = Y – (C + I + G )

implies


� The Link Between Trade and Capital Flows

implies

NX = (Y – C – G ) – I

= [Y – C(Y – T) – G ] – I(r*)

= S – I(r*)

Trade balance = Net capital outflow


Trade 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 ).


� The World’s Largest Debtor Nation� Every year since 1980s: huge trade deficits and

net capital inflows, i.e. net borrowing from abroadnet capital inflows, i.e. net borrowing from abroad

� As of 12/31/2009:

� U.S. residents owned $18.4 trillion worth of foreign assets

� Foreigners owned $21.1 trillion worth of U.S. assets


U.S. assets

� U.S. net indebtedness to rest of the world:$2.7 trillion--higher than any other country, hence U.S. is the “world’s largest debtor nation”

Learning Objectives




Exchange rates


Exchange rates

the U.S. as a large open economy

� Develop model of the flows of international capital and goods using a small open economy framework (SOE).

5.2) Saving and Investment in a SOE

goods using a small open economy framework (SOE).

� Use some elements familiar from chapter 3, however in an open-economy context:

� production function

� consumption function

Y Y F K L= = ( , )

C C Y T= −( )


� investment function

� exogenous policy variables

I I r= ( )

G G T T= =,

r ( )S Y C Y T G= − − −


� National Saving: Supply of Loanable Funds

As in Chapter 3,national saving does not depend on the

interest rate

As in Chapter 3,national saving does not depend on the

interest rate


S, IS

a. Domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.)


� Assumptions on Capital Flows

(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 a & b imply rr = = r*r*

c implies c implies r*r* is exogenousis exogenous

Investment is still a downward-sloping function

r


� Investment: Demand for Loanable Funds

downward-sloping functionof the interest rate,

r *

but the exogenous world interest rate…

…determines thecountry’s level of


country’s level ofinvestment.

I (r* ) S, I

I (r )

rS

…the interest …the interest


� If the Economy Were Closed…

rc

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

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


S, I

I (r)

cI

S

r

=( )

rS

the exogenous world interest the exogenous world interest


� But in a Small Open Economy…

Trade surplusS

rc

r*

world interest rate determines investment…

world interest rate determines investment…

…and the difference between saving

…and the difference between saving

NX

Trade surplus


S, I

I (r )

rc

I1

between saving and investment determines net capital outflow and net exports

between saving and investment determines net capital outflow and net exports

1. Fiscal policy at home


� Three Analyses…


2. Fiscal policy abroad

3. An increase in investment demand


r1S

An increase in Gor decrease in TAn increase in Gor decrease in T 2

S


� Fiscal Policy at Home

1Sor decrease in T

reduces saving.or decrease in Treduces saving.

1

*r

NX1

2S

NX2

Results:

0I∆ =


S, I

I (r )

I1

0NX S∆ = ∆ <

2%

8%Budget deficit

(left scale)


� NX and the Federal Budget Deficit

-2%

0%

2%

0%

2%

4%

6% (left scale)


-6%

-4%

-4%

-2%

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Net exports (right scale)

r1SExpansionary

fiscal policy NX2


� Fiscal Policy Abroad

fiscal policy abroad raises the world interest rate. 1

*r

NX1

NX2

Results: Results:

2

*r


S, I

I (r )

Results: Results:

0I∆ <0NX I∆ = −∆ >

1( )*I r

2( )*I r

rS


�该你们了: Increase in Investment Demand

EXERCISE:

Use the model to determine the impact of an increase in investment demand

EXERCISE:

Use the model to determine the impact of an increase in investment demand

NX1

*r

S


S, I

I (r )1

investment demand on NX, S, I, and net capital outflow.

investment demand on NX, S, I, and net capital outflow.

I1

Learning Objectives




Exchange rates


Exchange rates


5.3) Exchange Rates

� Nominal Exchange Rate

e = Nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Euro per Dollar, that is, how much Euro do I have to pay to obtain a Dollar)


have to pay to obtain a Dollar)

e.g.:e=0.74 €/$

Country Exchange rate

Euro area 0.74 Euro/$

5.3) Exchange Rates

� A Few Exchange Rates, as of 30/09/11

Euro area 0.74 Euro/$

China 6.40 RMB/$

Indonesia 8800 Rupiahs/$

Japan 76.56 Yen/$

Mexico 13.74 Pesos/$


Mexico 13.74 Pesos/$

Russia 31.98 Rubles/$

South Africa 7.98 Rand/$

U.K. 0.64 Pounds/$

ε

5.3) Exchange Rates

� Real Exchange Rate

= real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac, that is, how many Japanese Big Macs do I have to pay to obtain one U.S. Big Mac)

the lowercase

Greek letter

epsilon

ε


to obtain one U.S. Big Mac)

*

e P

P

×=ε

5.3) Exchange Rates

� Understanding the Units of ε

(Yen per $) ($ per unit U.S. goods)Yen per unit Japanese goods

×=

Yen per unit U.S. goodsYen per unit Japanese goods

=

*P


Units of Japanese goods

per unit of U.S. goods=

Yen per unit Japanese goods

5.3) Exchange Rates

� McZample

� one good: Big Mac� price in Japan: P* = 200 Yen� price in Japan: P* = 200 Yen� price in USA: P = $2.50� nominal exchange rate e = 120 Yen/$

To buy a U.S. Big Mac, someone from Japan

e P

P

×=*

ε


someone from Japan would have to pay an amount that could buy 1.5 Japanese Big Macs.

120 2 501 5

200 Yen

P

×= =

*

$ ..

� In the real world:

5.3) Exchange Rates

� ε in the Real World and Our Model

� In the real world:We can think of ε as the relative price of a basket of domestic goods in terms of a basket of foreign goods

� In our macro model:There’s just one good, “output.”


So ε is the relative price of one country’s output in terms of the other country’s output

↑ε ⇒ U.S. goods become more expensive relative to

5.3) Exchange Rates

� How NX depends on ε

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

⇒ ↓EX, ↑IM

⇒ ↓NX


1404% Trade-weighted real exchange rate index

5.3) Exchange Rates

�U.S. Net Exports and the Real Exchange RateN

X(%

of

GD

P)

Ind

ex(M

arch

197

3 =

100)

60

80

100

120

-4%

-2%

0%

2%

exchange rate index


Ind

ex

0

20

40

-8%

-6%

-4%

1970 1975 1980 1985 1990 1995 2000 2005 2010

Net exports(left scale)

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

5.3) Exchange Rates

� The Net Exports Function

relationship between NX and ε :

NX = NX(ε )


ε

5.3) Exchange Rates

� The NX Curve for the U.S.

ε1

When ε is relatively low, U.S. goods are relatively

so U.S. net exports will be high


0 NX

NX (ε)

ε1relatively

inexpensive

NX(ε1)

ε

ε

At high enough values of ε, U.S. goods

5.3) Exchange Rates

� The NX Curve for the U.S.

ε2

of ε, U.S. goods become so expensive that

exports are less than imports


0 NX

NX (ε)

NX(ε2)

� The accounting identity says NX = S – I

5.3) Exchange Rates

� How ε is Determined in the Model

� 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 *


rate r *

� r * adjusts to equate global savings and investment

� So, ε must adjust to ensure

( ) ( )*NX ε S I r= −

Neither S nor Idepend on ε, so the Neither S nor Idepend on ε, so the

ε 1( *)S I r−

5.3) Exchange Rates

� How ε is Determined in the Model (ctd.)

depend on ε, so the net capital outflow curve is vertical.

depend on ε, so the net capital outflow curve is vertical.

NX(ε )

ε adjusts to equate NXε adjusts to equate NX

ε 1


NX

NX(ε )equate NXwith net capital outflow, S − I.

equate NXwith net capital outflow, S − I. NX 1

Demand:Foreigners need Demand:Foreigners need

ε 1( *)S I r−

5.3) Exchange Rates

� Supply and Demand in the FX Market

Foreigners need dollars to buy U.S. net exports.

Foreigners need dollars to buy U.S. net exports.

NX(ε )

Supply: Net capital outflow (S − I )

Supply: Net capital outflow (S − I )

ε 1


NX

NX(ε )outflow (S − I ) is the supply of dollars to be invested abroad.

outflow (S − I ) is the supply of dollars to be invested abroad.

NX 1

5.3) Exchange Rates

� Four Analyses…


2. Fiscal policy abroad

3. An increase in investment demand

4. Trade policy to restrict imports


4. Trade policy to restrict imports

A fiscal expansion A fiscal expansion ε

2( *)S I r−

5.3) Exchange Rates

� 1. Fiscal Policy at Home

A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars in the foreign exchange market…

A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars in the foreign exchange market…

ε1

( *)S I r−

ε 1

ε 2


exchange market… exchange market…

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


NX

NX(ε )

NX 1NX 2

An increase in r*reduces investment, An increase in r*reduces investment, ε

1 1( *)S I r−

( )*S I r−

5.3) Exchange Rates

� 2. Fiscal Policy Abroad

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

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

ε

ε 1

21( )*S I r−

ε 2


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

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

NX

NX(ε )

NX 1NX 2

An increase in investment reduces An increase in investment reduces ε S I−

21S I−

5.3) Exchange Rates

� 3. Increase in Investment Demand

investment reduces net capital outflow and the supply of dollars in the foreign exchange market…

investment reduces net capital outflow and the supply of dollars in the foreign exchange market…

ε

ε 1

1 1S I−

ε 2


NX

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


NX 1NX 2

Trade policy doesn’t affect S or I , so cap. flows and dollar supply remain fixed.Trade policy doesn’t affect S or I , so cap. flows and dollar supply remain fixed.

5.3) Exchange Rates

� 4. Trade Policy to Restrict Imports

ε S I−

ε1

and dollar supply remain fixed.and dollar supply remain fixed.

ε2

At any given value of ε, an import quota causes⇒ ↓IM ⇒ NX curve shifts right⇒ This causes higher net capital demand from abroad to finance larger trade deficit


NX

NX (ε )1

NX1,2

ε1

NX (ε )2

finance larger trade deficit⇒ ε needs to adjust to equilibrate D and S⇒ Since at higher ε exports ↓, NX remains unchanged

Results:Results:

5.3) Exchange Rates

� 4. Trade Policy to Restrict Imports

∆∆∆∆ε > 0

(demand increase)

∆∆∆∆NX = 0 (supply fixed)

∆∆∆∆IM < 0 (policy)

∆∆∆∆EX < 0 (rise in ε )

∆∆∆∆ε > 0

(demand increase)

∆∆∆∆NX = 0 (supply fixed)

∆∆∆∆IM < 0 (policy)

∆∆∆∆EX < 0 (rise in ε )

ε S I−

ε1

ε2


NX

NX (ε )1

NX1,2

ε1

NX (ε )2

� Start with the expression for the real exchange rate:

5.3) Exchange Rates

� Determinants of the Nominal Exchange Rate

� Start with the expression for the real exchange rate:

*

e Pε

P

×=

� Solve for the nominal exchange rate:*

Pe ε= ×


Pe ε

P= ×

� So e depends on the real exchange rate and the price levels at home and abroad…

5.3) Exchange Rates


price levels at home and abroad…

…and we know how each of them is determined:

*P

e εP

= ×

** *

*( * *, )

ML r Y

P= + π


( * , )M

L r YP

= +π( ) ( )*NX ε S I r= −

e εP

= ×

*P

e εP

= ×

5.3) Exchange Rates


� Rewrite this equation in growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ):

P

*

*

e ε P P

e ε P P= + −∆ ∆ ∆ ∆∆ ∆ ∆ ∆∆ ∆ ∆ ∆∆ ∆ ∆ ∆ *ε

ε

π ππ ππ ππ π= + −∆∆∆∆


*e ε P P

= + −ε

π ππ ππ ππ π= + −

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

30

35Percentage Mexico

5.3) Exchange Rates

� Inflation Differentials and Nom. Ex. Rates

5

10

15

20

25

30Percentage

change in nominal

exchange rate

South Africa

Iceland

Mexico

Canada

Singapore


-5

0

5

-5 0 5 10 15 20 25 30Inflation differential

_

U.K.

South Korea

Japan

Two definitions:

� A doctrine that states that goods must sell at the

5.3) Exchange Rates

� Purchasing Power Parity

� A doctrine that states that goods must sell at the same (currency-adjusted) price in all countries.

� The nominal exchange rate adjusts to equalize the cost of a basket of goods across countries.

Reasoning:

� arbitrage, the. law of one price


� arbitrage, the. law of one price

� PPP: e ××××P = P* Cost of a basket of foreign goods, in

5.3) Exchange Rates


Cost of a basket of domestic goods, in foreign currency.

Cost of a basket of domestic goods, in domestic currency.

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.

� If e = P*/P, then

*

* *1

P P Pε e= × = × =

5.3) Exchange Rates


then * *

1ε eP P P

= × = × =

and the NX curve is horizontal:

ε

S - I Under PPP, changes in (S – I ) have no

Under PPP, changes in (S – I ) have no


NX

NXε = 1 (S – I ) have no impact on ε or e. (S – I ) have no impact on ε or e.

� No, for two reasons:

5.3) Exchange Rates

� Does PPP hold in the Real World?

1. International arbitrage not possible.� Non-traded goods� transportation costs

2. Different countries’ goods not perfect substitutes.

� Nonetheless, PPP is a useful theory:


� It’s simple & intuitive

� In the real world, nominal exchange rates tend toward their PPP values over the long run.

Learning Objectives




Exchange rates


Exchange rates


� So far, we’ve learned long-run models for two extreme cases:

5.4) The U.S. as a LOE


two extreme cases:

� closed economy (chap. 3)� small open economy (chap. 5)

� A large open economy – like the U.S. – fallsbetween these two extremes.


� The results from large open economy analysis are a mixture of the results for the closed & small open economy cases.

� For example…

A fiscal expansion causes national saving to fall.The effects of this depend on openness & size:

5.4) The U.S. as a LOE

� A Fiscal Expansion in Three Models

r

Large open economy

Small open economy

Closed economy

falls, but not as much no

rises, but not as much as in closed economy

nochange

rises

The effects of this depend on openness & size:


NX

I

falls, but not as much as in small open economy

fallsno

change

falls, but not as much as in closed economy

nochange

falls

Chapter Summary

� Net exports--the difference between � Net exports--the difference between � exports and imports� a country’s output (Y )

and its spending (C + I + G)

� Net capital outflow equals� purchases of foreign assets


� purchases of foreign assets minus foreign purchases of the country’s assets

� the difference between saving and investment

Chapter Summary (ctd.)

� National income accounts identities:� National income accounts identities:� Y = C + I + G + NX� trade balance NX = S - I net capital outflow

� Impact of policies on NX :

� NX increases if policy causes S to rise or I to fall


or I to fall� NX does not change if policy affects

neither S nor I. Example: trade policy

� Exchange rates


� Exchange rates

� nominal: the price of a country’s currency in terms of another country’s currency

� real: the price of a country’s goods in terms of another country’s goods

� The real exchange rate equals the nominal rate times


the ratio of prices of the two countries.

� 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


� How the nominal exchange rate is determined


� e equals the real exchange rate times the country’s price level relative to the foreign price level.

� For a given value of the real exchange rate, the percentage change in the nominal exchange rate equals the difference between the foreign & domestic inflation rates.


domestic inflation rates.

Documents

MACROECONOMICS Seventh Edition N. Gregory · PDF fileMACROECONOMICS Seventh Edition N. Gregory Mankiw ... ( e.g. Japanese Big Macs per U.S. Big Mac, that is, ... Supply and Demand