L9 Textbook Note PDF

IN THIS CHAPTER YOU WILL... Build a model to...

IN THIS CHAPTER YOU WILL... Build a model to explain an open economy’s trade balance and exchange rate Use the model to analyze the ef fects of government budget deficits A MACROECONOMIC THEORY OF THE OPEN ECONOMY Use the model to analyze the macroeconomic ef fects of trade Over the past decade, the United States has persistently imported more goods and policies services than it has exported. That is, U.S. net exports have been negative. Al- though economists debate whether these trade deficits are a problem for the U.S. economy, the nation’s business community has a strong opinion. Many business leaders claim that the trade deficits reflect unfair competition: Foreign firms are al- lowed to sell their products in U.S. markets, they contend, while foreign govern- ments impede U.S. firms from selling U.S. products abroad. Imagine that you are the president and you want to end these trade deficits. What should you do? Should you try to limit imports, perhaps by imposing a Use the model quota on the import of cars from Japan? Or should you try to influence the nation’s to analyze trade deficit in some other way? political instability To understand what factors determine a country’s trade balance and how and capital flight government policies can affect it, we need a macroeconomic theory of the open 679 680 PA R T E L E V E N THE MACROECONOMICS OF OPEN ECONOMIES economy. The preceding chapter introduced some of the key macroeconomic vari- ables that describe an economy’s relationship with other economies—including net exports, net foreign investment, and the real and nominal exchange rates. This chapter develops a model that shows what forces determine these variables and how these variables are related to one another. To develop this macroeconomic model of an open economy, we build on our previous analysis in two important ways. First, the model takes the economy’s GDP as given. We assume that the economy’s output of goods and services, as measured by real GDP, is determined by the supplies of the factors of production and by the available production technology that turns these inputs into output. Second, the model takes the economy’s price level as given. We assume the price level adjusts to bring the supply and demand for money into balance. In other words, this chapter takes as a starting point the lessons learned in Chapters 24 and 28 about the determination of the economy’s output and price level. The goal of the model in this chapter is to highlight those forces that determine the economy’s trade balance and exchange rate. In one sense, the model is simple: It merely applies the tools of supply and demand to an open economy. Yet the model is also more complicated than others we have seen because it involves look- ing simultaneously at two related markets—the market for loanable funds and the market for foreign-currency exchange. After we develop this model of the open economy, we use it to examine how various events and policies affect the econ- omy’s trade balance and exchange rate. We will then be able to determine the gov- ernment policies that are most likely to reverse the trade deficits that the U.S. economy has experienced over the past decade. S U P P LY A N D D E M A N D F O R L O A N A B L E F U N D S AND FOR FOREIGN-CURRENCY EXCHANGE To understand the forces at work in an open economy, we focus on supply and de- mand in two markets. The first is the market for loanable funds, which coordinates the economy’s saving and investment (including its net foreign investment). The second is the market for foreign-currency exchange, which coordinates people who want to exchange the domestic currency for the currency of other countries. In this section we discuss supply and demand in each of these markets. In the next section we put these markets together to explain the overall equilibrium for an open economy. THE MARKET FOR LOANABLE FUNDS When we first analyzed the role of the financial system in Chapter 25, we made the simplifying assumption that the financial system consists of only one market, called the market for loanable funds. All savers go to this market to deposit their sav- ing, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.  CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 681 To understand the market for loanable funds in an open economy, the place to start is the identity discussed in the preceding chapter: S
I  NFI Saving
Domestic investment  Net foreign investment. Whenever a nation saves a dollar of its income, it can use that dollar to finance the purchase of domestic capital or to finance the purchase of an asset abroad. The two sides of this identity represent the two sides of the market for loanable funds. The supply of loanable funds comes from national saving (S). The demand for loanable funds comes from domestic investment (I) and net foreign investment (NFI). Note that the purchase of a capital asset adds to the demand for loanable funds, regard- less of whether that asset is located at home or abroad. Because net foreign invest- ment can be either positive or negative, it can either add to or subtract from the demand for loanable funds that arises from domestic investment. As we learned in our earlier discussion of the market for loanable funds, the quantity of loanable funds supplied and the quantity of loanable funds demanded depend on the real interest rate. A higher real interest rate encourages people to save and, therefore, raises the quantity of loanable funds supplied. A higher inter- est rate also makes borrowing to finance capital projects more costly; thus, it dis- courages investment and reduces the quantity of loanable funds demanded. In addition to influencing national saving and domestic investment, the real interest rate in a country affects that country’s net foreign investment. To see why, consider two mutual funds—one in the United States and one in Germany—de- ciding whether to buy a U.S. government bond or a German government bond. The mutual funds would make this decision in part by comparing the real interest rates in the United States and Germany. When the U.S. real interest rate rises, the U.S. bond becomes more attractive to both mutual funds. Thus, an increase in the U.S. real interest rate discourages Americans from buying foreign assets and encourages foreigners to buy U.S. assets. For both reasons, a high U.S. real interest rate reduces U.S. net foreign investment. We represent the market for loanable funds on the familiar supply-and- demand diagram in Figure 30-1. As in our earlier analysis of the financial system, the supply curve slopes upward because a higher interest rate increases the quan- tity of loanable funds supplied, and the demand curve slopes downward because a higher interest rate decreases the quantity of loanable funds demanded. Unlike the situation in our previous discussion, however, the demand side of the market now represents the behavior of both domestic investment and net foreign invest- ment. That is, in an open economy, the demand for loanable funds comes not only from those who want to borrow funds to buy domestic capital goods but also from those who want to borrow funds to buy foreign assets. The interest rate adjusts to bring the supply and demand for loanable funds into balance. If the interest rate were below the equilibrium level, the quantity of loanable funds supplied would be less than the quantity demanded. The resulting shortage of loanable funds would push the interest rate upward. Conversely, if the interest rate were above the equilibrium level, the quantity of loanable funds sup- plied would exceed the quantity demanded. The surplus of loanable funds would drive the interest rate downward. At the equilibrium interest rate, the supply of loanable funds exactly balances the demand. That is, at the equilibrium interest rate, 682 PA R T E L E V E N THE MACROECONOMICS OF OPEN ECONOMIES Figure 30-1 Real T HE M ARKET FOR Interest Rate L OANABLE F UNDS. The interest Supply of loanable funds rate in an open economy, as in a (from national saving) closed economy, is determined by the supply and demand for loanable funds. National saving is the source of the supply of loanable funds. Domestic Equilibrium real interest investment and net foreign rate investment are the sources of the Demand for loanable demand for loanable funds. At funds (for domestic investment and net the equilibrium interest rate, foreign investment) the amount that people want to save exactly balances the amount that people want to borrow for Equilibrium Quantity of quantity Loanable Funds the purpose of buying domestic capital and foreign assets. the amount that people want to save exactly balances the desired quantities of domestic in- vestment and net foreign investment. THE MARKET FOR FOREIGN-CURRENCY EXCHANGE The second market in our model of the open economy is the market for foreign- currency exchange. Participants in this market trade U.S. dollars in exchange for foreign currencies. To understand the market for foreign-currency exchange, we begin with another identity from the last chapter: NFI
NX Net foreign investment
Net exports. This identity states that the imbalance between the purchase and sale of capital as- sets abroad (NFI) equals the imbalance between exports and imports of goods and services (NX). When U.S. net exports are positive, for instance, foreigners are buy- ing more U.S. goods and services than Americans are buying foreign goods and services. What are Americans doing with the foreign currency they are getting from this net sale of goods and services abroad? They must be adding to their holdings of foreign assets, which means U.S. net foreign investment is positive. Conversely, if U.S. net exports are negative, Americans are spending more on for- eign goods and services than they are earning from selling abroad; this trade deficit must be financed by selling American assets abroad, so U.S. net foreign in- vestment is negative as well. Our model of the open economy assumes that the two sides of this identity represent the two sides of the market for foreign-currency exchange. Net foreign investment represents the quantity of dollars supplied for the purpose of buying assets abroad. For example, when a U.S. mutual fund wants to buy a Japanese  CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 683 Figure 30-2 Real Exchange T HE M ARKET FOR F OREIGN - Rate C URRENCY E XCHANGE. The real Supply of dollars (from net foreign investment) exchange rate is determined by the supply and demand for foreign-currency exchange. The supply of dollars to be exchanged into foreign currency comes from Equilibrium net foreign investment. Because real exchange net foreign investment does not rate depend on the real exchange rate, Demand for dollars the supply curve is vertical. The (for net exports) demand for dollars comes from net exports. Because a lower real exchange rate stimulates net Equilibrium Quantity of Dollars Exchanged exports (and thus increases the quantity into Foreign Currency quantity of dollars demanded to pay for these net exports), the demand curve is downward sloping. At the equilibrium real government bond, it needs to change dollars into yen, so it supplies dollars in the exchange rate, the number of market for foreign-currency exchange. Net exports represent the quantity of dol- dollars people supply to buy lars demanded for the purpose of buying U.S. net exports of goods and services. foreign assets exactly balances For example, when a Japanese airline wants to buy a plane made by Boeing, the number of dollars people it needs to change its yen into dollars, so it demands dollars in the market for demand to buy net exports. foreign-currency exchange. What price balances the supply and demand in the market for foreign- currency exchange? The answer is the real exchange rate. As we saw in the pre- ceding chapter, the real exchange rate is the relative price of domestic and foreign goods and, therefore, is a key determinant of net exports. When the U.S. real ex- change rate appreciates, U.S. goods become more expensive relative to foreign goods, making U.S. goods less attractive to consumers both at home and abroad. As a result, exports from the United States fall, and imports into the United States rise. For both reasons, net exports fall. Hence, an appreciation of the real exchange rate reduces the quantity of dollars demanded in the market for foreign-currency exchange. Figure 30-2 shows supply and demand in the market for foreign-currency ex- change. The demand curve slopes downward for the reason we just discussed: A higher real exchange rate makes U.S. goods more expensive and reduces the quantity of dollars demanded to buy those goods. The supply curve is vertical because the quantity of dollars supplied for net foreign investment does not depend on the real exchange rate. (As discussed earlier, net foreign investment depends on the real interest rate. When discussing the market for foreign-currency exchange, we take the real interest rate and net foreign investment as given.) The real exchange rate adjusts to balance the supply and demand for dollars just as the price of any good adjusts to balance supply and demand for that good. If the real exchange rate were below the equilibrium level, the quantity of dollars supplied would be less than the quantity demanded. The resulting shortage of dol- lars would push the value of the dollar upward. Conversely, if the real exchange 684 PA R T E L E V E N THE MACROECONOMICS OF OPEN ECONOMIES rate were above the equilibrium level, the quantity of dollars supplied would ex- ceed the quantity demanded. The surplus of dollars would drive the value of the dollar downward. At the equilibrium real exchange rate, the demand for dollars by for- eigners arising from the U.S. net exports of goods and services exactly balances the supply of dollars from Americans arising from U.S. net foreign investment. At this point, it is worth noting that the division of transactions between “sup- ply” and “demand” in this model is somewhat artificial. In our model, net exports are the source of the demand for dollars, and net foreign investment is the source of the supply. Thus, when a U.S. resident imports a car made in Japan, our model treats that transaction as a decrease in the quantity of dollars demanded (because net exports fall) rather than an increase in the quantity of dollars supplied. Simi- larly, when a Japanese citizen buys a U.S. government bond, our model treats that transaction as a decrease in the quantity of dollars supplied (because net foreign investment falls) rather than an increase in the quantity of dollars demanded. This use of language may seem somewhat unnatural at first, but it will prove useful when analyzing the effects of various policies. Q U I C K Q U I Z : Describe the sources of supply and demand in the market for loanable funds and the market for foreign-currency exchange. EQUILIBRIUM IN THE OPEN ECONOMY So far we have discussed supply and demand in two markets—the market for loanable funds and the market for foreign-currency exchange. Let’s now consider how these markets are related to each other. FYI Purchasing- An alert reader of this book were cheaper in one country than in another, they would be might ask: Why are we develop- exported from the first country and imported into the sec- Power Parity as ing a theory of the exchange ond until the price difference disappeared. In other words, a Special Case rate here? Didn’t we already do the theory of purchasing-power parity assumes that net ex- that in the preceding chapter? ports are highly responsive to small changes in the real ex- As you may recall, the pre- change rate. If net exports were in fact so responsive, the ceding chapter developed a demand curve in Figure 30-2 would be horizontal. theory of the exchange rate Thus, the theory of purchasing-power parity can be called purchasing-power parity. viewed as a special case of the model considered here. In This theory asserts that a dol- that special case, the demand curve for foreign-currency ex- lar (or any other currency) must change, rather than being downward sloping, is horizontal at buy the same quantity of goods the level of the real exchange rate that ensures parity of and services in every country. purchasing power at home and abroad. That special case is As a result, the real exchange rate is fixed, and all changes a good place to start when studying exchange rates, but it is in the nominal exchange rate between two currencies reflect far from the end of the story. changes in the price levels in the two countries. This chapter, therefore, concentrates on the more real- The model of the exchange rate developed here is re- istic case in which the demand curve for foreign-currency ex- lated to the theory of purchasing-power parity. According to change is downward sloping. This allows for the possibility the theory of purchasing-power parity, international trade re- that the real exchange rate changes over time, as in fact it sponds quickly to international price differences. If goods sometimes does in the real world.  CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 685 NET FOREIGN INVESTMENT : THE LINK BETWEEN THE TWO MARKETS We begin by recapping what we’ve learned so far in this chapter. We have been discussing how the economy coordinates four important macroeconomic vari- ables: national saving (S), domestic investment (I), net foreign investment (NFI), and net exports (NX). Keep in mind the following identities: S
I  NFI and NFI
NX. In the market for loanable funds, supply comes from national saving, demand comes from domestic investment and net foreign investment, and the real interest rate balances supply and demand. In the market for foreign-currency exchange, supply comes from net foreign investment, demand comes from net exports, and the real exchange rate balances supply and demand. Net foreign investment is the variable that links these two markets. In the mar- ket for loanable funds, net foreign investment is a piece of demand. A person who wants to buy an asset abroad must finance this purchase by borrowing in the mar- ket for loanable funds. In the market for foreign-currency exchange, net foreign in- vestment is the source of supply. A person who wants to buy an asset in another country must supply dollars in order to exchange them for the currency of that country. The key determinant of net foreign investment, as we have discussed, is the real interest rate. When the U.S. interest rate is high, owning U.S. assets is more attractive, and U.S. net foreign investment is low. Figure 30-3 shows this negative Figure 30-3 Real Interest H OW N ET F OREIGN I NVESTMENT Rate D EPENDS ON THE I NTEREST R ATE. Because a higher domestic real interest rate makes domestic assets more attractive, it reduces net foreign investment. Note the position of zero on the horizontal axis: Net foreign investment can be either positive or negative. Net foreign investment 0 Net foreign investment Net Foreign is negative. is positive. Investment 686 PA R T E L E V E N THE MACROECONOMICS OF OPEN ECONOMIES relationship between the interest rate and net foreign investment. This net-foreign- investment curve is the link between the market for loanable funds and the mar- ket for foreign-currency exchange. S I M U LTA N E O U S E Q U I L I B R I U M I N T W O M A R K E T S We can now put all the pieces of our model together in Figure 30-4. This figure shows how the market for loanable funds and the market for foreign-currency (a) The Market for Loanable Funds (b) Net Foreign Investment Real Real Interest Supply Interest Rate Rate r1 r1 Net foreign Demand investment, NFI Quantity of Net Foreign Loanable Funds Investment Real Exchange Supply Rate E1 Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange T HE R EAL E QUILIBRIUM IN AN O PEN E CONOMY. In panel (a), the supply and demand for Figure 30-4 loanable funds determine the real interest rate. In panel (b), the interest rate determines net foreign investment, which provides the supply of dollars in the market for foreign- currency exchange. In panel (c), the supply and demand for dollars in the market for foreign-currency exchange determine the real exchange rate.  CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 687 exchange jointly determine the important macroeconomic variables of an open economy. Panel (a) of the figure shows the market for loanable funds (taken from Fig- ure 30-1). As before, national saving is the source of the supply of loanable funds. Domestic investment and net foreign investment are the source of the demand for loanable funds. The equilibrium real interest rate (r1) brings the quantity of loan- able funds supplied and the quantity of loanable funds demanded into balance. Panel (b) of the figure shows net foreign investment (taken from Figure 30-3). It shows how the interest rate from panel (a) determines net foreign investment. A higher interest rate at home makes domestic assets more attractive, and this in turn reduces net foreign investment. Therefore, the net-foreign-investment curve in panel (b) slopes downward. Panel (c) of the figure shows the market for foreign-currency exchange (taken from Figure 30-2). Because net foreign investment must be paid for with foreign currency, the quantity of net foreign investment from panel (b) determines the sup- ply of dollars to be exchanged into foreign currencies. The real exchange rate does not affect net foreign investment, so the supply curve is vertical. The demand for dollars comes from net exports. Because a depreciation of the real exchange rate in- creases net exports, the demand curve for foreign-currency exchange slopes down- ward. The equilibrium real exchange rate (E1) brings into balance the quantity of dollars supplied and the quantity of dollars demanded in the market for foreign- currency exchange. The two markets shown in Figure 30-4 determine two relative prices—the real interest rate and the real exchange rate. The real interest rate determined in panel (a) is the price of goods and services in the present relative to goods and services in the future. The real exchange rate determined in panel (c) is the price of domes- tic goods and services relative to foreign goods and services. These two relative prices adjust simultaneously to balance supply and demand in these two markets. As they do so, they determine national saving, domestic investment, net foreign investment, and net exports. In a moment, we will use this model to see how all these variables change when some policy or event causes one of these curves to shift. Q U I C K Q U I Z : In the model of the open economy just developed, two markets determine two relative prices. What are the markets? What are the two relative prices? HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY Having developed a model to explain how key macroeconomic variables are de- termined in an open economy, we can now use the model to analyze how changes in policy and other events alter the economy’s equilibrium. As we proceed, keep in mind that our model is just supply and demand in two markets—the market for loanable funds and the market for foreign-currency exchange. When using the model to analyze any event, we can apply the three steps outlined in Chapter 4. 688 PA R T E L E V E N THE MACROECONOMICS OF OPEN ECONOMIES First, we determine which of the supply and demand curves the event affects. Second, we determine which way the curves shift. Third, we use the supply-and- demand diagrams to examine how these shifts alter the economy’s equilibrium. GOVERNMENT BUDGET DEFICITS When we first discussed the supply and demand for loanable funds earlier in the book, we examined the effects of government budget deficits, which occur when government spending exceeds government revenue. Because a government bud- get deficit represents negative public saving, it reduces national saving (the sum of public and private saving). Thus, a government budget deficit reduces the supply of loanable funds, drives up the interest rate, and crowds out investment. Now let’s consider the effects of a budget deficit in an open economy. First, which curve in our model shifts? As in a closed economy, the initial impact of the budget deficit is on national saving and, therefore, on the supply curve for loan- able funds. Second, which way does this supply curve shift? Again as in a closed economy, a budget deficit represents negative public saving, so it reduces national saving and shifts the supply curve for loanable funds to the left. This is shown as the shift from S1 to S2 in panel (a) of Figure 30-5. Our third and final step is to compare the old and new equilibria. Panel (a) shows the impact of a U.S. budget deficit on the U.S. market for loanable funds. With fewer funds available for borrowers in U.S. financial markets, the interest rate rises from r1 to r2 to balance supply and demand. Faced with a higher interest rate, borrowers in the market for loanable funds choose to borrow less. This change is represented in the figure as the movement from point A to point B along the demand curve for loanable funds. In particular, households and firms reduce their purchases of capital goods. As in a closed economy, budget deficits crowd out domestic investment. In an open economy, however, the reduced supply of loanable funds has addi- tional effects. Panel (b) shows that the increase in the interest rate from r1 to r2 re- duces net foreign investment. [This fall in net foreign investment is also part of the decrease in the quantity of loanable funds demanded in the movement from point A to point B in panel (a).] Because saving kept at home now earns higher rates of return, investing abroad is less attractive, and domestic residents buy fewer for- eign assets. Higher interest rates also attract foreign investors, who want to earn the higher returns on U.S. assets. Thus, when budget deficits raise interest rates, both domestic and foreign behavior cause U.S. net foreign investment to fall. Panel (c) shows how budget deficits affect the market for foreign-currency ex- change. Because net foreign investment is reduced, people need less foreign cur- rency to buy foreign assets, and this induces a leftward shift in the supply curve for dollars from S1 to S2. The reduced supply of dollars causes the real exchange rate to appreciate from E1 to E2. That is, the dollar becomes more valuable com- pared to foreign currencies. This appreciation, in turn, makes U.S. goods more ex- pensive compared to foreign goods. Because people both at home and abroad switch their purchases away from the more expensive U.S. goods, exports from the United States fall, and imports into the United States rise. For both reasons, U.S. net exports fall. Hence, in an open economy, government budget deficits raise real inter- est rates, crowd out domestic investment, cause the dollar to appreciate, and push the trade balance toward deficit.  CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 689 1. A budget deficit reduces (a) The Market for Loanable Funds (b) Net Foreign Investment the supply of loanable funds... Real Real Interest S2 S1 Interest Rate Rate B r2 r2 A r1 r1 3.... which in 2.... which turn reduces increases net foreign the real Demand investment. interest NFI rate... Quantity of Net Foreign Loanable Funds Investment Real Exchange S2 S1 Rate 4. The decrease in net foreign investment reduces the supply of dollars to be exchanged E2 into foreign E1 currency... 5.... which causes the real exchange rate to Demand appreciate. Quantity of Dollars (c) The Market for Foreign-Currency Exchange T HE E FFECTS OF A G OVERNMENT B UDGET D EFICIT. When the government runs a budget Figure 30-5 deficit, it reduces the supply of loanable funds from S1 to S2 in panel (a). The interest rate rises from r1 to r2 to balance the supply and demand for loanable funds. In panel (b), the higher interest rate reduces net foreign investment. Reduced net foreign investment, in turn, reduces the supply of dollars in the market for foreign-currency exchange from S1 to S2 in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate from E1 to E2. The appreciation of the exchange rate pushes the trade balance toward deficit. An important example of this lesson occurred in the United States in the 1980s. Shortly after Ronald Reagan was elected president in 1980, the fiscal policy of the U.S. federal government changed dramatically. The president and Congress enacted large cuts in taxes, but they did not cut government spending by nearly as 690 PA R T E L E V E N THE MACROECONOMICS OF OPEN ECONOMIES much, so the result was a large budget deficit. Our model of the open economy predicts that such a policy should lead to a trade deficit, and in fact it did, as we saw in a case study in the preceding chapter. The budget deficit and trade deficit during this period were so closely related in both theory and practice that they earned the nickname the twin deficits. We should not, however, view these twins as identical, for many factors beyond fiscal policy can influence the trade deficit. TRADE POLICY trade policy A trade policy is a government policy that directly influences the quantity of a government policy that directly goods and services that a country imports or exports. As we saw in Chapter 9, influences the quantity of goods trade policy takes various forms. One common trade policy is a tariff, a tax on im- and services that a country ported goods. Another is an import quota, a limit on the quantity of a good that can imports or exports be produced abroad and sold domestically. Trade policies are common throughout the world, although sometimes they are disguised. For example, the U.S. govern- ment has often pressured Japanese automakers to reduce the number of cars they sell in the United States. These so-called “voluntary export restrictions” are not re- ally voluntary and, in essence, are a form of import quota. Let’s consider the macroeconomic impact of trade policy. Suppose that the U.S. auto industry, concerned about competition from Japanese automakers, convinces the U.S. government to impose a quota on the number of cars that can be imported from Japan. In making their case, lobbyists for the auto industry assert that the trade restriction would shrink the size of the U.S. trade deficit. Are they right? Our model, as illustrated in Figure 30-6, offers an answer. The first step in analyzing the trade policy is to determine which curve shifts. The initial impact of the import restriction is, not surprisingly, on imports. Because net exports equal exports minus imports, the policy also affects net exports. And because net exports are the source of demand for dollars in the market for foreign- currency exchange, the policy affects the demand curve in this market. The second step is to determine which way this demand curve shifts. Because the quota restricts the number of Japanese cars sold in the United States, it reduces imports at any given real exchange rate. Net exports, which equal exports minus imports, will therefore rise for any given real exchange rate. Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency exchange. This increase in the demand for dollars is shown in panel (c) of Figure 30-6 as the shift from D1 to D2. The third step is to compare the old and new equilibria. As we can see in panel (c), the increase in the demand for dollars causes the real exchange rate to appreci- ate from E1 to E2. Because nothing has happened in the market for loanable funds in panel (a), there is no change in the real interest rate. Because there is no change in the real interest rate, there is also no change in net foreign investment, shown in panel (b). And because there is no change in net foreign investment, there can be no change in net exports, even though the import quota has reduced imports. The reason why net exports can stay the same while imports fall is explained by the change in the real exchange rate: When the dollar appreciates in value in the market for foreign-currency exchange, domestic goods become more expensive relative to foreign goods. This appreciation encourages imports and discourages exports—and both of these changes work to offset the direct increase in net exports  CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 691 (a) The Market for Loanable Funds (b) Net Foreign Investment Real Real Interest Supply Interest Rate Rate r1 r1 3. Net exports, however, remain the same. Demand NFI Quantity of Net Foreign Loanable Funds Investment Real Exchange Supply Rate 1. An import quota increases the demand for E2 dollars... 2.... and causes the E1 real exchange rate to D2 appreciate. D1 Quantity of Dollars (c) The Market for Foreign-Currency Exchange T HE E FFECTS OF AN I MPORT Q UOTA. When the U.S. government imposes a quota on the Figure 30-6 import of Japanese cars, nothing happens in the market for loanable funds in panel (a) or to net foreign investment in panel (b). The only effect is a rise in net exports (exports minus imports) for any given real exchange rate. As a result, the demand for dollars in the market for foreign-currency exchange rises, as shown by the shift from D1 to D2 in panel (c). This increase in the demand for dollars causes the value of the dollar to appreciate from E1 to E2. This appreciation of the dollar tends to reduce net exports, offsetting the direct effect of the import quota on the trade balance. due to the import quota. In the end, an import quota reduces both imports and exports, but net exports (exports minus imports) are unchanged. We have thus come to a surprising implication: Trade policies do not affect the trade balance. That is, policies that directly influence exports or imports do not alter 692 PA R T E L E V E N THE MACROECONOMICS OF OPEN ECONOMIES net exports. This conclusion seems less surprising if one recalls the accounting identity: NX
NFI
S  I. Net exports equal net foreign investment, which equals national saving minus domestic investment. Trade policies do not alter the trade balance because they do not alter national saving or domestic investment. For given levels of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same, regardless of the trade policies the government puts in place. Although trade policies do not affect a country’s overall trade balance, these policies do affect specific firms, industries, and countries. When the U.S. govern- ment imposes an import quota on Japanese cars, General Motors has less competi- tion from abroad and will sell more cars. At the same time, because the dollar has appreciated in value, Boeing, the U.S. aircraft maker, will find it harder to compete with Airbus, the European aircraft maker. U.S. exports of aircraft will fall, and U.S. imports of aircraft will rise. In this case, the import quota on Japanese cars will in- crease net exports of cars and decrease net exports of planes. In addition, it will increase net exports from the United States to Japan and decrease net exports from the United States to Europe. The overall trade balance of the U.S. economy, how- ever, stays the same. The effects of trade policies are, therefore, more microeconomic than macro- economic. Although advocates of trade policies sometimes claim (incorrectly) that these policies can alter a country’s trade balance, they are usually more motivated by concerns about particular firms or industries. One should not be surprised, for instance, to hear an executive from General Motors advocating import quotas for Japanese cars. Economists almost always oppose such trade policies. As we saw in Chapters 3 and 9, free trade allows economies to specialize in doing what they do best, making residents of all countries better off. Trade restrictions interfere with these gains from trade and, thus, reduce overall economic well-being. P O L I T I C A L I N S TA B I L I T Y A N D C A P I TA L F L I G H T In 1994 political instability in Mexico, including the assassination of a prominent political leader, made world financial markets nervous. People began to view Mexico as a much less stable country than they had previously thought. They decided to pull some of their assets out of Mexico in order to move these funds to the United States and other “safe havens.” Such a large and sudden movement of capital flight funds out of a country is called capital flight. To see the implications of capital a large and sudden reduction in flight for the Mexican economy, we again follow our three steps for analyzing a the demand for assets located change in equilibrium, but this time we apply our model of the open economy in a country from the perspective of Mexico rather than the United States. Consider first which curves in our model capital flight affects. When investors around the world observe political problems in Mexico, they decide to sell some of their Mexican assets and use the proceeds to buy U.S. assets. This act increases Mexican net foreign investment and, therefore, affects both markets in our model. Most obviously, it affects the net-foreign-investment curve, and this in turn influ- ences the supply of pesos in the market for foreign-currency exchange. In addition, because the demand for loanable funds comes from both domestic investment and net foreign investment, capital flight affects the demand curve in the market for loanable funds.  CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 693 Now consider which way these curves shift. When net foreign investment in- creases, there is greater demand for loanable funds to finance these purchases. Thus, as panel (a) of Figure 30-7 shows, the demand curve for loanable funds shifts to the right from D1 to D2. In addition, because net foreign investment is higher for (a) The Market for Loanable Funds in Mexico (b) Mexican Net Foreign Investment Real Real Interest Supply Interest 1. An increase Rate Rate in net foreign investment... r2 r2 r1 r1 3.... which D2 increases the interest D1 rate. NFI1 NFI2 2.... increases the demand Quantity of Net Foreign for loanable funds... Loanable Funds Investment Real Exchange S1 S2 Rate 4. At the same time, the increase in net foreign investment E1 increases the 5.... which supply of pesos... E2 causes the peso to depreciate. Demand Quantity of Pesos (c) The Market for Foreign-Currency Exchange T HE E FFECTS OF C APITAL F LIGHT. If people decide that Mexico is a risky place to keep Figure 30-7 their savings, they will move their capital to safer havens such as the United States, resulting in an increase in Mexican net foreign investment. Consequently, the demand for loanable funds in Mexico rises from D1 to D2, as shown in panel (a), and this drives up the Mexican real interest rate from r1 to r2. Because net foreign investment is higher for any interest rate, that curve also shifts to the right from NFI1 to NFI2 in panel (b). At the same time, in the market for foreign-currency exchange, the supply of pesos rises from S1 to S2, as shown in panel (c). This increase in the supply of pesos causes the peso to depreciate from E1 to E2, so the peso becomes less valuable compared to other currencies. 694 PA R T E L E V E N THE MACROECONOMICS OF OPEN ECONOMIES any interest rate, the net-foreign-investment curve also shifts to the right from NFI1 to NFI2, as in panel (b). To see the effects of capital flight on the economy, we compare the old and new equilibria. Panel (a) of Figure 30-7 shows that the increased demand for loanable funds causes the interest rate in Mexico to rise from r1 to r2. Panel (b) shows that Mexican net foreign investment increases. (Although the rise in the interest rate does make Mexican assets more attractive, this development only partly offsets the impact of capital flight on net foreign investment.) Panel (c) shows that the increase in net foreign investment raises the supply of pesos in the market for foreign-currency exchange from S1 to S2. That is, as people try to get out of Mexi- can assets, there is a large supply of pesos to be converted into dollars. This in- crease in supply causes the peso to depreciate from E1 to E2. Thus, capital flight from Mexico increases Mexican interest rates and decreases the value of the Mexican peso in the market for foreign-currency exchange. This is exactly what was observed in 1994. From November 1994 to March 1995, the interest rate on short-term Mexican gov- ernment bonds rose from 14 percent to 70 percent, and the peso depreciated in value from 29 to 15 U.S. cents per peso. Although capital flight has its largest impact on the country from which capi- tal is fleeing, it also affects other countries. When capital flows out of Mexico into the United States, for instance, it has the opposite effect on the U.S. economy as it has on the Mexican economy. In particular, the rise in Mexican net foreign invest- ment coincides with a fall in U.S. net foreign investment. As the peso depreciates in value and Mexican interest rates rise, the dollar appreciates in value and U.S. in- terest rates fall. The size of this impact on the U.S. economy is small, however, be- cause the economy of the United States is so large compared to that of Mexico. The events that we have been describing in Mexico could happen to any econ- omy in the world, and in fact they do from time to time. In 1997, the world learned that the banking systems of several Asian economies, including Thailand, South Korea, and Indonesia, were at or near the point of bankruptcy, and this news in- duced capital to flee from these nations. In 1998, the Russian government de- faulted on its debt, inducing international investors to take whatever money they could and run. In each of these cases of capital flight, the results were much as our model predicts: rising interest rates and a falling currency. Could capital flight ever happen in the United States? Although the U.S. econ- omy has long been viewed as a safe economy in which to invest, political devel- opments in the United States have at times induced small amounts of capital flight. For example, the September 22, 1995, issue of The New York Times reported that on the previous day, “House Speaker Newt Gingrich threatened to send the United States into default on its debt for the first time in the nation’s history, to force the Clinton administration to balance the budget on Republican terms” (p. A1). Even though most people believed such a default was unlikely, the effect of the announcement was, in a small way, similar to that experienced by Mexico in 1994. Over the course of that single day, the interest rate on a 30-year U.S. govern- ment bond rose from 6.46 percent to 6.55 percent, and the exchange rate fell from 102.7 to 99.0 yen per dollar. Thus, even the stable U.S. economy is potentially sus- ceptible to the effects of capital flight. Q U I C K Q U I Z : Suppose that Americans decided to spend a smaller fraction of their incomes. What would be the effect on saving, investment, interest rates, the real exchange rate, and the trade balance?  CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 695 CONCLUSION International economics is a topic of increasing importance. More and more, American citizens are buying goods produced abroad and producing goods to be sold overseas. Through mutual funds and other financial institutions, they borrow and lend in world financial markets. As a result, a full analysis of the U.S. economy requires an understanding of how the U.S. economy interacts with other econo- mies in the world. This chapter has provided a basic model for thinking about the macroeconomics of open economies. Although the study of international economics is valuable, we should be care- ful not to exaggerate its importance. Policymakers and commentators are often quick to blame foreigners for problems facing the U.S. economy. By contrast, econ- omists more often view these problems as homegrown. For example, politicians often discuss foreign competition as a threat to American living standards. Econo- mists are more likely to lament the low level of national saving. Low saving im- pedes growth in capital, productivity, and living standards, regardless of whether the economy is open or closed. Foreigners are a convenient target for politicians because blaming foreigners provides a way to avoid responsibility without insult- ing any domestic constituency. Whenever you hear popular discussions of inter- national trade and finance, therefore, it is especially important to try to separate myth from reality. The tools you have learned in the past two chapters should help in that endeavor. Summary ◆ To analyze the macroeconomics of open economies, two foreign-currency exchange. The dollar appreciates, and markets are central—the market for loanable funds and net exports fall. the market for foreign-currency exchange. In the market ◆ Although restrictive trade policies, such as tariffs or for loanable funds, the interest rate adjusts to balance quotas on imports, are sometimes advocated as a way to the supply of loanable funds (from national saving) and alter the trade balance, they do not necessarily have that the demand for loanable funds (from domestic effect. A trade restriction increases net exports for a investment and net foreign investment). In the market given exchange rate and, therefore, increases the for foreign-currency exchange, the real exchange rate demand for dollars in the market for foreign-currency adjusts to balance the supply of dollars (for net foreign exchange. As a result, the dollar appreciates in value, investment) and the demand for dollars (for net making domestic goods more expensive relative to exports). Because net foreign investment is part of the foreign goods. This appreciation offsets the initial demand for loanable funds and provides the supply of impact of the trade restriction on net exports. dollars for foreign-currency exchange, it is the variable ◆ When investors change their attitudes about holding that connects these two markets. assets of a country, the ramifications for the country’s ◆ A policy that reduces national saving, such as a economy can be profound. In particular, political government budget deficit, reduces the supply of instability can lead to capital flight, which tends to loanable funds and drives up the interest rate. The increase interest rates and cause the currency to higher interest rate reduces net foreign investment, depreciate. which reduces the supply of dollars in the market for 696 PA R T E L E V E N THE MACROECONOMICS OF OPEN ECONOMIES the world’s industrialized powers. But IN THE NEWS China, with fat trade surpluses and bulg- How the Chinese Help ing foreign-exchange reserves, is buying U.S. government securities, especially American Home Buyers Treasury bonds and bonds issued by Fannie Mae and Freddie Mac. That’s good for America. Such in- vestments add liquidity to the U.S. hous- ing market and help hold down U.S. interest rates. And China is likely to con- tinue to buy a lot of U.S. debt for years THIS ARTICLE DESCRIBES HOW CAPITAL IS to come. flowing from China into the United Thanks to high domestic savings, a States. Can you predict what would continuing inflow of foreign investment happen to the U.S. economy if these and tight controls on domestic spending, capital flows stopped? China is awash in capital. Last year’s capital surplus... reached an estimated $67 billion. China, of All Places, China squirrels more than half of T HEIR SAVING HELPS US GET Sends Capital to U.S. that away into foreign reserves, which CHEAP MORTGAGES. are invested abroad. Chinese companies funnel much of the rest directly overseas BY CRAIG S. SMITH through bank transfers—sometimes capital-sucking hole, China has become SHANGHAI, CHINA—A giant, developing skirting Chinese capital restrictions to a gushing fountain of capital. nation bordered by an economic quag- do so. So while the financial crisis has This isn’t the first time a developing mire is an unlikely source of capital for transformed the rest of East Asia into a country has sent abroad funds that could Key Concepts trade policy, p. 690 capital flight, p. 692 Questions for Review 1. Describe supply and demand in the market for loanable policy do to the trade balance and the real exchange funds and the market for foreign-currency exchange. rate? What is the impact on the textile industry? What is How are these markets linked? the impact on the auto industry? 2. Why are budget deficits and trade deficits sometimes 4. What is capital flight? When a country experiences called the twin deficits? capital flight, what is the effect on its interest rate and 3. Suppose that a textile workers’ union encourages people exchange rate? to buy only American-made clothes. What would this  CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 697 be used productively at home. Often, of its gross domestic product was an ex- concessions in Sudan, Venezuela, Iraq such money was fleeing instability, as traordinarily high 34 percent in 1996, the and Kazakstan. Mainland capital also has it was in Latin America in the 1980s, latest year for which figures are avail- poured into Hong Kong, where it helped Russia in the 1990s, and Africa in both able. It’s doubtful that China could in- inflate property prices before East Asia’s decades. crease that ratio without wasting money crisis began letting out some of that air. Usually, however, developing coun- or fueling inflation. Thailand’s ratio was The capital surplus has even allowed tries invest their capital in their own 40 percent and Korea’s 37 percent China to help its neighbors when they growing economies. And some Chinese before their overspending undermined got into trouble: Beijing pledged $1 bil- officials believe that’s what China should those nations’ economies.... lion to the International Monetary Fund be doing, too. One former Chinese cen- “They’re already investing as much bailouts in Thailand and Indonesia. Most tral bank official calls it “scandalous” as they can absorb,” says Andy Xie, an of the money, though, goes into U.S. that a country of poor peasants is financ- economist for Morgan Stanley Dean Treasury bonds. China won’t say how ing investment of an industrialized power Witter & Co. in Hong Kong. much, but estimates run as high as such as the United States. Yet while investment is constrained, 40 percent. Others complain that China isn’t savings keep growing. The percentage And China’s central bank, like 50 even getting good returns on its invest- of working-age people in the population others around the world, lends money to ments. It pays an average of 7 to 8 per- has climbed to 62 percent from 51 per- Fannie Mae and Freddie Mac, which use cent on its $130 billion foreign debt but cent in the past 30 years. And those the funds to buy mortgage loans that earns only about 5 percent on the $140 workers, often allowed only one child on banks and others extend to ordinary billion of its reserves invested abroad. which to spend, are hitting their peak Americans. The flood of money keeps That’s partly because yields on U.S. saving years. With consumption low, the the market liquid and reduces the rates debt—widely considered the safest se- pileup of money pushes capital offshore. that U.S. home buyers pay. curities in the world—are relatively low. The result: Chinese capital is But China has good reasons to spreading everywhere. The country is SOURCE: The Wall Street Journal, March 30, 1998, send some of its capital overseas. Its in- a big buyer of oil fields, for example, The Outlook, p. 1. vestment in fixed assets as a percentage having pledged more than $8 billion for Problems and Applications 1. Japan generally runs a significant trade surplus. Do you policy affect national saving, domestic investment, net think this is most related to high foreign demand for foreign investment, the interest rate, the exchange rate, Japanese goods, low Japanese demand for foreign and the trade balance? goods, a high Japanese saving rate relative to Japanese 4. The chapter notes that the rise in the U.S. trade deficit investment, or structural barriers against imports into during the 1980s was due largely to the rise in the U.S. Japan? Explain your answer. budget deficit. On the other hand, the popular press 2. An article in The New York Times (Apr. 14, 1995) sometimes claims that the increased trade deficit regarding a decline in the value of the dollar reported resulted from a decline in the quality of U.S. products that “the president was clearly determined to signal that relative to foreign products. the United States remains solidly on a course of deficit a. Assume that U.S. products did decline in relative reduction, which should make the dollar more attractive quality during the 1980s. How did this affect net to investors.” Would deficit reduction in fact raise the exports at any given exchange rate? value of the dollar? Explain. b. Use a three-panel diagram to show the effect of this 3. Suppose that Congress passes an investment tax credit, shift in net exports on the U.S. real exchange rate which subsidizes domestic investment. How does this and trade balance. 698 PA R T E L E V E N THE MACROECONOMICS OF OPEN ECONOMIES c. Is the claim in the popular press consistent with the b. If the elasticity of U.S. exports with respect to the model in this chapter? Does a decline in the quality real exchange rate is very low, will this increase in of U.S. products have any effect on our standard of private saving have a large or small effect on the living? (Hint: When we sell our goods to foreigners, U.S. real exchange rate? what do we receive in return?) 10. Over the past decade, some of Japanese saving has been 5. An economist discussing trade policy in The New used to finance American investment. That is, American Republic wrote: “One of the benefits of the United States net foreign investment in Japan has been negative. removing its trade restrictions [is] the gain to U.S. a. If the Japanese decided they no longer wanted to industries that produce goods for export. Export buy U.S. assets, what would happen in the U.S. industries would find it easier to sell their goods market for loanable funds? In particular, what abroad—even if other countries didn’t follow our would happen to U.S. interest rates, U.S. saving, example and reduce their trade barriers.” Explain in and U.S. investment? words why U.S. export industries would benefit from a b. What would happen in the market for foreign- reduction in restrictions on imports to the United States. currency exchange? In particular, what would 6. Suppose the French suddenly develop a strong taste for happen to the value of the dollar and the U.S. California wines. Answer the following questions in trade balance? words and using a diagram. 11. In 1998 the Russian government defaulted on its debt a. What happens to the demand for dollars in the payments, leading investors worldwide to raise their market for foreign-currency exchange? preference for U.S. government bonds, which are b. What happens to the value of dollars in the market considered very safe. What effect do you think this for foreign-currency exchange? “flight to safety” had on the U.S. economy? Be sure c. What happens to the quantity of net exports? to note the impact on national saving, domestic 7. A senator renounces her past support for protectionism: investment, net foreign investment, the interest rate, “The U.S. trade deficit must be reduced, but import the exchange rate, and the trade balance. quotas only annoy our trading partners. If we subsidize 12. Suppose that U.S. mutual funds suddenly decide to U.S. exports instead, we can reduce the deficit by invest more in Canada. increasing our competitiveness.” Using a three-panel a. What happens to Canadian net foreign investment, diagram, show the effect of an export subsidy on net Canadian saving, and Canadian domestic exports and the real exchange rate. Do you agree with investment? the senator? b. What is the long-run effect on the Canadian 8. Suppose that real interest rates increase across Europe. capital stock? Explain how this development will affect U.S. net c. How will this change in the capital stock affect the foreign investment. Then explain how it will affect U.S. Canadian labor market? Does this U.S. investment net exports by using a formula from the chapter and by in Canada make Canadian workers better off or using a diagram. What will happen to the U.S. real worse off? interest rate and real exchange rate? d. Do you think this will make U.S. workers better off or worse off? Can you think of any reason why the 9. Suppose that Americans decide to increase their saving. impact on U.S. citizens generally may be different a. If the elasticity of U.S. net foreign investment with from the impact on U.S. workers? respect to the real interest rate is very high, will this increase in private saving have a large or small effect on U.S. domestic investment?