Macroeconomics: The Open Economy - N. Gregory Mankiw

Macroeconomics N. Gregory Mankiw The Open Economy Presentation Slides © 2022 Worth Publishers, all rights reserved  IN THIS CHAPTER, YOU WILL LEARN: Accounting identities for the open...

Macroeconomics N. Gregory Mankiw The Open Economy Presentation Slides © 2022 Worth Publishers, all rights reserved  IN THIS CHAPTER, YOU WILL LEARN: Accounting identities for the open economy The small open-economy model what makes it “small” how the trade balance and exchange rate are determined how policies affect trade balance and exchange rate 3 The CHAPTER 1 National Science Income of Macroeconomics Imports and exports of selected countries, 2013 In an open economy, spending need not equal output saving need not equal investment The national income identity in an open economy  Preliminaries d f C =C +C superscripts: d = spending on I =Id +If domestic goods f = spending on G =G d +G f foreign goods EX = exports = foreign spending on domestic goods IM = imports = C f + I f + G f = spending on foreign goods NX = net exports (a.k.a. the “trade balance”) = EX – IM  GDP = expenditure on domestically produced goods & services Y = C d + I d + G d + EX f f f = (C − C ) + (I − I ) + (G − G ) + EX = C + I + G + EX − (C f + I f + G f ) = C + I + G + EX − IM = C + I + G + NX Trade surpluses and deficits NX = X – IM = Y – (C + I + G) Trade surplus: output > spending and exports (X) > imports (IM) Size of the trade surplus = NX Trade deficit: spending > output and imports > exports Size of the trade deficit = –NX International capital flows Net capital outflow =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 The link between trade and capital flows NX = Y – (C + I + G ) implies NX = (Y – C – G ) – I =S–I trade balance = net capital outflow Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ).  Saving, investment, and the trade balance 1960– 2019 The United States: The world’s largest debtor nation Every year since the 1980s: huge trade deficits and net capital inflows (that is, net borrowing from abroad) As of December 31, 2014: U.S. residents owned $24.7 trillion worth of foreign assets Foreigners owned $31.6 trillion worth of U.S. assets U.S. net indebtedness to the rest of the world: $6.9 trillion—higher than any other country, hence the United States is the “world’s largest debtor nation” Saving and investment in a small open economy An open-economy version of the loanable funds model from Chapter 3 Includes many of the same elements: production function Y = Y = F (K , L) consumption function C = C(Y − T ) investment function I = I (r ) exogenous policy variables G = G,T = T National saving: The supply of loanable funds As in Chapter 3, national saving does not depend on the interest rate Assumptions about capital flows a. Domestic and foreign bonds are perfect substitutes (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 and b imply r = r* c implies r* is exogenous Investment and the real interest rate r Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate… r* …determines the country’s level of investment. I (r ) I (r* ) I  If the economy were closed… r S …the interest rate would adjust to equate investment and saving: rc I (r ) I (rc ) S, I =S  But in a small open economy… r the exogenous S world interest rate determines investment… NX r* …and the difference rc between saving and investment I (r ) determines net capital outflow I1 S, I and net exports Three experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand (exercise)  1. Fiscal policy at home r S 2 S1 An increase in G or decrease in T NX2 reduces saving. r 1 * NX1 Results: I = 0 NX = S  0 I (r ) I1 S, I NX and the federal budget deficit (% of GDP), 1960–2020  2. Fiscal policy abroad r Expansionary S1 NX2 fiscal policy abroad raises r 2* NX1 the world interest rate. r1 * Results: I  0 I (r ) NX = −I  0 S, I I (r ) 2 * I (r1* )  NOW YOU TRY: 3. An increase in investment demand r Use the S model to determine r* the impact of an increase NX1 in investment demand on NX, S, I, and I (r )1 net capital outflow. I1 S, I  ANSWERS: 3. An increase in investment demand r S I > 0, NX2 S = 0, r* net capital outflow and NX fall NX1 by the I (r )2 amount I I (r )1 I1 I2 S, I The nominal exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (example: yen per dollar)  A few exchange rates, as of 1/31/2020 Country Exchange rate Euro area 0.82 euro/$ Indonesia 14,030 rupiahs/$ Japan 104.70 yen/$ Mexico 20.48 pesos/$ Russia 65.85 rubles/$ South Africa 15.16 rand/$ U.K. 0.73 pounds/$ USD/KZT exchange rate Source: National Bank of Kazakhstan The real exchange rate (ε) = real exchange rate, the relative price of domestic goods in terms of foreign goods (example: Japanese Big Macs per U.S. Big Mac) Understanding the units of ε e×P ε= P* = ( Yen per $ )  ( $ per unit U.S. goods ) Yen per unit Japanese goods Yen per unit U.S. goods = Yen per unit Japanese goods Units of Japanese goods = per unit of U.S. goods ~ McZample ~ One good: Big Mac e×P Price in Japan: ε= P* = 200 yen P* 120 × $2.50 Price in the United States: = = 1.5 P = $2.50 200 Yen Nominal exchange rate e = 120 yen/$ To buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy 1.5 Japanese Big Macs. 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. How NX depends on ε If ε rises: U.S. goods become more expensive relative to foreign goods exports fall, imports rise net exports fall The net exports function The net exports function reflects this inverse relationship between NX and ε : NX = NX(ε )  The NX curve for the United States, part 1...so U.S. net exports will be high. When ε is relatively low, U.S. goods are relatively inexpensive... The NX curve for the United States, part 2 At high enough values of ε, U.S. goods become so expensive that we export less than we import. How ε is determined (1 of 2) 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 * So, ε must adjust to ensure NX (ε ) = S − I (r *)  How ε is determined (2 of 2) Neither S nor I depends on ε, so the net capital outflow curve is vertical. ε adjusts to equate NX with net capital outflow, S − I.  Interpretation: Supply and demand in the foreign exchange market Demand: Foreigners need dollars to buy U.S. net exports. Supply: Net capital outflow (S - I ) is the supply of dollars to be invested abroad. Four experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand (exercise) 4. Trade policy to restrict imports  1. Fiscal policy at home A fiscal expansion S 2 − I (r *) reduces national ε S 1 − I (r *) saving, net capital outflow, and the ε2 supply of dollars in the foreign exchange market… ε1 NX(ε ) …causing the real NX exchange rate to rise NX 2 NX 1 and NX to fall.  2. Fiscal policy abroad An increase in r* S 1 − I (r1 *) reduces ε S 1 − I (r2 *) investment, increasing net capital outflow and ε1 the supply of dollars in the foreign exchange ε2 market… NX(ε ) …causing the real NX NX 1 NX 2 exchange rate to fall and NX to rise.  NOW YOU TRY: 3. Increase in investment demand Determine the ε S1 − I 1 impact of an increase in investment demand on net exports, ε1 net capital outflow, NX(ε ) and the real NX exchange rate NX 1  ANSWERS: 3. Increase in investment demand An increase in S1 − I 2 investment ε S1 − I 1 reduces net capital outflow ε2 and the supply of dollars in the foreign ε1 exchange market… NX(ε ) …causing the real NX NX 2 NX 1 exchange rate to rise and NX to fall.  4. Trade policy to restrict imports At any given value of ε, an import quota ε S −I  IM  NX  demand for ε2 dollars shifts right ε1 NX (ε )2 Trade policy doesn’t NX (ε )1 affect S or I , so capital flows and the NX NX1 supply of dollars remain fixed.  4. Trade policy to restrict imports Results: ε S −I ε > 0 (demand increase) ε2 NX = 0 (supply fixed) ε1 IM < 0 NX (ε )2 (policy) NX (ε )1 EX < 0 (rise in ε ) NX NX1 The determinants of the nominal exchange rate, part 1 Start with the expression for the real exchange rate: e×P ε= * P Solve for the nominal exchange rate: P* e =ε × P The determinants of the nominal exchange rate, part 2 So e depends on the real exchange rate and the price levels at home and abroad... and we know how each of them is determined: The determinants of the nominal exchange rate, part 3 P* e=ε× P Rewrite this equation in growth rates (see “Two Helpful Hints for Working with Percentage Changes” in Chapter 2): Δe Δε ΔP * ΔP Δε = + * − = + π* − π e ε P P ε For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates. Inflation differentials and nominal exchange rates for a cross section of countries Purchasing-power parity (PPP), part 1 Two definitions: 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 Purchasing-power parity (PPP), part 2 ▪ Solve for e: e = P*/ P ▪ PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels. Purchasing-power parity (PPP), part 3 If e = P * / P , P P* P then ε = e × * = × * =1 P P P and the NX curve is horizontal : Under PPP, changes in (S – I ) have no impact on ε or e. Does PPP hold in the real world? No, for two reasons: 1. International arbitrage is difficult nontraded goods transportation costs 2. Different countries’ goods are not perfect substitutes Yet PPP is a useful theory: It’s simple and intuitive. In the real world, nominal exchange rates tend toward their PPP values over the long run.  CASE STUDY: The Reagan Deficits Revisited 1970s 1980s Actual Closed Small open change economy economy G-T 2.2 3.9    S 19.6 17.4    r 1.1 6.3   no change I 19.9 19.4   no change NX -0.3 -2.0  no change  ε 115.1 129.4  no change  Data: Decade averages; all except r and ε are expressed as a percentage of GDP; ε is a trade-weighted index. The United States as a large open economy So far, we’ve learned long-run models for two extreme cases: closed economy (Chapter 3) small open economy (Chapter 5) A large open economy—like the United States—falls between these two extremes. The results from large open-economy analysis are a mixture of the results for the closed and small open- economy cases. For example...  A fiscal expansion in three models A fiscal expansion causes national saving to fall. The effects of this depend on openness and size. Closed Large open economy Small open economy economy r rises rises, but not as much no change as in a closed economy I falls falls, but not as much in no change a closed economy NX no change falls, but not as much as falls in an open economy  CHAPTER SUMMARY, PART 1 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 minus foreign purchases of the country’s assets ▪ the difference between saving and investment 3 The CHAPTER 1 National Science Income of Macroeconomics  CHAPTER SUMMARY, PART 2 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 NX does not change if policy affects neither S nor I (example: trade policy) 3 The CHAPTER 1 National Science Income of Macroeconomics  CHAPTER SUMMARY, PART 3 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. 3 The CHAPTER 1 National Science Income of Macroeconomics  CHAPTER SUMMARY, PART 4 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. 3 The CHAPTER 1 National Science Income of Macroeconomics  CHAPTER SUMMARY, PART 5 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 and domestic inflation rates. 3 The CHAPTER 1 National Science Income of Macroeconomics