Macroeconomics Past Paper PDF 2014 Update

6 The Open Economy MACROECONOMICS N. Gregory Mankiw ® Fall 2014 PowerPoint Slides by Ron Cronovich update © 2015 Worth Publishers, all rights reserved ...

6 The Open Economy MACROECONOMICS N. Gregory Mankiw ® Fall 2014 PowerPoint Slides by Ron Cronovich update © 2015 Worth Publishers, all rights reserved  Introduction  Even if you never leave your hometown, you are a participant in the global economy.  When you go to the grocery store, you might choose between apples grown locally and grapes grown in Chile.  When you make a deposit into your local bank, the bank might lend those funds to your next-door neighbor or to a Japanese company building a factory outside Tokyo CHAPTER 6 The Open Economy 1  Introduction  In previous chapters we simplified the analysis by assuming a closed economy.  Yet most actual economies are open:  They export goods and services abroad, they import goods and services from abroad  They borrow and lend in world financial markets.  Accounting identities reveal a key insight: the flow of goods and services across national borders is always matched by an equivalent flow of funds to finance capital accumulation. CHAPTER 6 The Open Economy 2  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 3  Imports and exports of selected countries, 2012 60 Exports 50 Imports Percent of GDP 40 30 20 10 0 Australia China Germany Greece S. Korea Mexico United States  In an open economy,  The key macroeconomic difference between open and closed economies is that, in an open economy, a country’s spending in any given year need not equal its output of goods and services.  A country can spend more than it produces by borrowing from abroad, or it can spend less than it produces and lend the difference to foreigners. CHAPTER 6 The Open Economy 5  In an open economy,  spending need not equal output  saving need not equal investment CHAPTER 6 The Open Economy 6  The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G ) domestic net exports spending output CHAPTER 6 The Open Economy 7  Trade surpluses and deficits NX = Y – (C + I + G ) net exports domestic output spending  This equation shows that in an open economy, domestic spending need not equal the output of goods and services.  If a country’s output exceeds its domestic spending, it exports the difference: net exports are positive.  If a country’s output falls short of its domestic spending, it imports the difference: net exports are negative CHAPTER 6 The Open Economy 8  Trade surpluses and deficits NX = EX – IM = Y – (C + I + G )  trade surplus: output > spending and exports > imports Size of the trade surplus = NX  trade deficit: spending > output and imports > exports Size of the trade deficit = –NX CHAPTER 6 The Open Economy 9  International Capital Flows and the Trade Balance CHAPTER 6 The Open Economy 10  International capital flows Y − C − G = I + NX Y−C−G is national saving S S = I + NX S – I = NX. Let’s look more closely at each part of this identity. The right-hand side, NX, is net exports of goods and services. Another name for net exports is the trade balance, because it tells us how a country’s trade in goods and services departs from the benchmark of equal imports and exports. CHAPTER 6 The Open Economy 11  International capital flows The left-hand side of the identity is the difference between domestic saving and domestic investment, S−I, which we’ll call net capital outflow (NCO) (It’s sometimes called net foreign investment.) In chapter 3, we examined a closed economy model of the loanable funds market. Savers could only lend money to domestic borrowers. Firms borrowing to finance their investment could only borrow from domestic savers. Thus, S = I. But in an open economy, S need not equal I. A country’s supply of loanable funds can be used to finance domestic investment, or to finance foreign investment (e.g. buying bonds from a foreign company that needs funding to build a new factory in its country). CHAPTER 6 The Open Economy 12  International capital flows  Similarly, domestic firms can finance their investment projects by borrowing loanable funds from domestic savers or by borrowing them from foreign savers.  International borrowing and lending is called “international capital flows”  The equation “net capital outflow = S – I” shows that  If a country’s savers supply more funds than its firms wish to borrow for investment, the excess of loanable funds will flow abroad in the form of net capital outflow (the purchase of foreign assets).  Alternatively, if firms wish to borrow more than domestic savers wish to lend, then the firms borrow the excess on international financial markets; in this case, there’s a net inflow of loanable funds, and S < I (Purchase of domestic assets) CHAPTER 6 The Open Economy 13  International capital flows The left-hand side of the identity is the difference between domestic saving and domestic investment, S−I, which we’ll call net capital outflow (NCO) (It’s sometimes called net foreign investment.) Net capital outflow = Purchase of foreign assets by domestic residents - Purchase of domestic assets by foreigners.. CHAPTER 6 The Open Economy 14  International capital flows Net capital outflow = Purchase of foreign assets by domestic residents - Purchase of domestic assets by foreigners When a U.S. resident buys stock in Petrobras, the Brazilian energy company, the purchase increases the first term on the right side of this equation (S) and, therefore, increases U.S. net capital outflow. When a Japanese resident buys a bond issued by the U.S. government, the purchase increases the second term on the right side of this equation (I) and, therefore, decreases U.S. net capital outflow. CHAPTER 6 The Open Economy 15  International capital flows If net capital outflow is positive, the economy’s saving exceeds its investment, and it is lending the excess to foreigners. If the net capital outflow is negative, the economy is experiencing a capital inflow: investment exceeds saving, and the economy is financing this extra investment by borrowing from abroad. CHAPTER 6 The Open Economy 16  The Equality of Net Exports and Net Capital Outflow  An important but subtle fact of accounting states that, for an economy as a whole, net capital outflow (NCO) must always equal net exports (NX): Net capital outflow (NCO) = net exports (NX) This equation holds because every transaction that affects one side of this equation affects the other side by exactly the same amount. This equation is an identity CHAPTER 6 The Open Economy 17  This table shows the three outcomes that an open economy can experience. Trade Surplus Balanced Trade Trade Deficit Exports > Imports Exports = Imports Exports0 Net Exports=0 Net ExportsC+I+G Y=C+I+G Y Investment Saving = Investment Saving < Investment Net Capital Outflow>0 Net Capital Outflow=0 Net Capital Outflow I, country is a net lender A country has a trade surplus. In this case, it is a net lender in world financial markets, and it exports more than it imports  When S < I, country is a net borrower A country has a trade deficit. In this case, it is a net borrower in world financial markets, and it imports more than it exports  When S = I balanced trade a country is said to have balanced trade because its imports and exports are equal in value. CHAPTER 6 The Open Economy 19  The link between trade & cap. 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 ). CHAPTER 6 The Open Economy 20  Saving, investment, and the trade balance 1960–2014 30% 20% investment Saving, Investment (% of GDP) 25% 15% Trade Balance (% of GDP) 20% 10% saving 15% 5% 10% 0% 5% trade balance -5% (right scale) 0% -10% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015  U.S.: The world’s largest debtor nation  Every year since 1980s: huge trade deficits and net capital inflows, i.e. net borrowing from abroad  As of 3/30/2014:  U.S. residents owned $23.6 trillion worth of foreign assets  Foreigners owned $29.1 trillion worth of U.S. assets  U.S. net indebtedness to rest of the world: $5.5 trillion—higher than any other country, hence U.S. is the “world’s largest debtor nation” CHAPTER 6 The Open Economy 22  Saving and investment in a small open economy CHAPTER 6 The Open Economy 23 Saving and investment in a small open economy Because the trade balance equals the net capital outflow, which in turn equals saving minus investment, our model focuses on saving and investment. To develop this model, we use some elements that should be familiar from Chapter 3, but unlike with the Chapter 3 model, we do not assume that the real interest rate equilibrates saving and investment. Instead, we allow the economy to run a trade deficit and borrow from other countries or to run a trade surplus and lend to other countries. If the real interest rate does not adjust to equilibrate saving and investment in this model, what does determine the real interest rate? We answer this question here by considering the simple case of a small open economy with perfect capital mobility. CHAPTER 6 The Open Economy 24  Saving and investment in a small open economy  A small open economy mean that this economy is a small part of the world market and thus, by itself, has only a negligible effect on the world interest rate  Perfect capital mobility mean that residents of the country have full access to world financial markets. In particular, the government does not impede international borrowing or lending. CHAPTER 6 The Open Economy 25  Saving and investment in a small open economy  Because of this assumption of perfect capital mobility, the interest rate in our small open economy r, must equal the world interest rate r*, the real interest rate prevailing in world financial markets r = r* A small open economy takes the world interest rate as exogenously given. CHAPTER 6 The Open Economy 26  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 CHAPTER 6 The Open Economy 27  Saving and investment in a small open economy  These are the three key parts of our model. If you do not understand these relationships, review Chapter 3 before continuing.  We can now return to the accounting identity and write it as NX = (Y − C − G) − I NX = S −I CHAPTER 6 The Open Economy 28  Saving and investment in a small open economy  Substituting the Chapter 3 assumptions recapped above and the assumption that the interest rate equals the world interest rate, we obtain CHAPTER 6 The Open Economy 29  Saving and investment in a small open economy  This equation shows that the trade balance NX depends on those variables that determine saving S and investment I.  Because saving depends on fiscal policy (lower government purchases G or higher taxes T raise national saving) and investment depends on the world real interest rate r*, the trade balance depends on these variables as well. CHAPTER 6 The Open Economy 30  National saving: The supply of loanable funds r S  Y  C (Y  T )  G As in Chapter 3, national saving does not depend on the interest rate S S, I CHAPTER 6 The Open Economy 31  Investment: The demand for loanable funds 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* ) S, I CHAPTER 6 The Open Economy 32  If the economy were closed… r S …the interest rate would adjust to equate investment and saving: rc I (r ) interest rate if the economy were closed I (rc ) S, I S CHAPTER 6 The Open Economy 33 CHAPTER 6 The Open Economy 34  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 CHAPTER 6 The Open Economy 35  Next, three experiments: In the small open economy, however, the real interest rate equals the world real interest rate. The trade balance is determined by the difference between saving and investment at the world interest rate CHAPTER 6 The Open Economy 36  Next, three experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand (exercise) CHAPTER 6 The Open Economy 37  1. Fiscal policy at home r S2 S1 An increase in G or decrease in T NX2 reduces saving. r1 * NX1 Results: I  0 NX  S  0 I (r ) I1 S, I CHAPTER 6 The Open Economy 38  Fiscal policy at home The increase in G reduces national saving. With an unchanged world real interest rate, investment remains the same. Therefore, saving falls below investment, and some investment must now be financed by borrowing from abroad. Because NX=S−I, the fall in S implies a fall in NX The same logic applies to a decrease in taxes. A tax cut lowers T, raises disposable income Y−T, stimulates consumption, and reduces national saving. Because NX=S−I, the reduction in national saving in turn lowers NX CHAPTER 6 The Open Economy 39 NX and the federal budget deficit (% of GDP), 1965–2014 10% 2% Budget deficit 8% (left scale) 0% 6% 4% -2% 2% 0% -4% Net exports -2% (right scale) -4% -6% 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015  2. Fiscal policy abroad Consider now what happens to a small open economy when foreign governments increase their government purchases. If these foreign countries are a small part of the world economy, then their fiscal change has a negligible impact on other countries. But if these foreign countries are a large part of the world economy, their increase in government purchases reduces world saving. CHAPTER 6 The Open Economy 41  2. Fiscal policy abroad r S1 Expansionary NX2 fiscal policy abroad raises r2* NX1 the world r1 * interest rate. Results: I  0 I (r ) NX  I  0 S, I I (r ) 2 * I (r1* ) CHAPTER 6 The Open Economy 42  2. Fiscal policy abroad The increase in the world interest rate raises the cost of borrowing and, thus, reduces investment in our small open economy. Because there has been no change in domestic saving, saving S now exceeds investment I, and some of the country’s saving begins to flow abroad. Because NX=S−I, the reduction in I must also increase NX. Hence, reduced saving abroad implies a increase in NX CHAPTER 6 The Open Economy 43  3. An increase in investment demand Consider what happens to a small open economy if its investment schedule shifts outward so there is greater demand for investment goods at every interest rate. This shift would occur if, for example, the government changed the tax laws to encourage investment by providing an investment tax credit CHAPTER 6 The Open Economy 44 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 45 ANSWERS 3. An increase in investment demand r S ΔI > 0, NX2 ΔS = 0, r* net capital outflow and NX fall NX1 by the I (r )2 amount ΔI I (r )1 I1 I2 S, I 46  3. An increase in investment demand At a given world interest rate, investment is now higher. Because saving is unchanged, some investment must now be financed by borrowing from abroad. Because capital flows into the economy to finance the increased investment, the net capital outflow is negative. Put differently, because NX=S−I, the increase in I implies a decrease in NX CHAPTER 6 The Open Economy 47  Exchange Rates CHAPTER 6 The Open Economy 48  Exchange Rates  Having examined the international flows of capital and of goods and services, we now extend the analysis by considering the prices that apply to these transactions.  The exchange rate between two countries is the price at which residents of those countries trade with each other CHAPTER 6 The Open Economy 49   Economists distinguish between two exchange rates: the nominal exchange rate and the real exchange rate. CHAPTER 6 The Open Economy 50  The Nominal Exchange Rate  The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another.  For example, when you go to a bank, you might see a posted exchange rate of 80 yen per dollar.  If you give the bank 1 U.S. dollar, you will receive 80 Japanese yen in return; and if you give the bank 80 Japanese yen, you will receive 1 U.S. dollar.  An exchange rate can always be expressed in two ways. If the exchange rate is 80 yen per dollar, it is also 1/80 (5 0.0125) dollar per yen. CHAPTER 6 The Open Economy 51  The nominal exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. yen per dollar) CHAPTER 6 The Open Economy 52  A few exchange rates, as of 6/26/2014 country exchange rate Euro area 0.73 euro/$ Indonesia 12,101 rupiahs/$ Japan 101.7 yen/$ Mexico 13.0 pesos/$ Russia 33.69 rubles/$ South Africa 10.65 rand/$ U.K. 0.59 pounds/$ CHAPTER 6 The Open Economy 53  The Real Exchange Rate  The real exchange rate is the relative price of the goods of two countries.  That is, the real exchange rate tells us the rate at which we can trade the goods of one country for the goods of another. The real exchange rate is sometimes called the terms of trade..  For example, if you go shopping and find that a pound of Swiss cheese is twice as expensive as a pound of American cheese, the real exchange rate is 1 /2 pound of Swiss cheese per pound of American cheese. CHAPTER 6 The Open Economy 54  The Real Exchange Rate  Notice that, like the nominal exchange rate, we express the real exchange rate as units of the foreign item per unit of the domestic item. But in this instance, the item is a good rather than a currency CHAPTER 6 The Open Economy 55  The real exchange rate ε = real exchange rate, the relative price of the lowercase domestic goods Greek letter in terms of foreign goods epsilon (e.g. Japanese Big Macs per U.S. Big Mac) CHAPTER 6 The Open Economy 56  The Real Exchange Rate Real and nominal exchange rates are closely related. For example, suppose that a bushel of American rice sells for $100 and a bushel of Japanese rice sells for 16,000 yen. What is the real exchange rate between American and Japanese rice? To answer this question, we must first use the nominal exchange rate to convert the prices into a common currency. If the nominal exchange rate is 80 yen per dollar, then a price for American rice of $100 per bushel is equivalent to 8,000 yen per bushel. American rice is half as expensive as Japanese rice. The real exchange rate is 1/2 bushel of Japanese rice per bushel of American rice CHAPTER 6 The Open Economy 57  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 CHAPTER 6 The Open Economy 58  ~ McZample ~  one good: Big Mac  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, e P someone from Japan ε  would have to pay an P* amount that could buy 120  $2.50   1.5 1.5 Japanese Big Macs. 200 Yen CHAPTER 6 The Open Economy 59  ε in the real world & 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 CHAPTER 6 The Open Economy 60  How NX depends on ε  The real exchange rate between two countries is computed from the nominal exchange rate and the price levels in the two countries. – If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. –If the real exchange rate is low, foreign goods are relatively expensive, and domestic goods are relatively cheap CHAPTER 6 The Open Economy 61  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 CHAPTER 6 The Open Economy 62  Figure illustrates the negative relationship between the trade balance and the real exchange rate CHAPTER 6 The Open Economy 63  U.S. net exports and the real exchange rate, 1973–2014 Trade-weighted real exchange rate index Index (March 1973 = 100) NX (% of GDP) Net exports (left scale) CHAPTER 6 The Open Economy 64  The net exports function  The net exports function reflects this inverse relationship between NX and ε : NX = NX(ε ) CHAPTER 6 The Open Economy 65  The NX curve for the U.S. ε so U.S. net When ε is exports will relatively low, be high U.S. goods are relatively ε1 inexpensive NX (ε) 0 NX(ε1) NX CHAPTER 6 The Open Economy 66  The NX curve for the U.S. ε At high enough values of ε, ε2 U.S. goods become so expensive that we export less than we import NX (ε) NX(ε2) 0 NX CHAPTER 6 The Open Economy 67  How ε is determined  The accounting identity says NX = S – I NX (Net exports) = NCO (Net capital outflow) This identity states that the imbalance between the purchase and sale of capital assets abroad (NCO) equals the imbalance between exports and imports of goods and services (NX). CHAPTER 6 The Open Economy 68  How ε is determined  The accounting identity says Net exports = Net capital outflow  Our model of the open economy treats the two sides of this identity as representing the two sides of the market for foreign-currency exchange. – Net capital outflow represents the quantity of dollars supplied for the purpose of buying foreign assets. – Net exports represent the quantity of dollars demanded for the purpose of buying U.S. net exports of goods and services CHAPTER 6 The Open Economy 69  How ε is determined  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 *) CHAPTER 6 The Open Economy 70  Interpretation: supply and demand in the foreign exchange market demand: ε S 1  I (r *) Foreigners need dollars to buy U.S. net exports. supply: Net capital outflow (S  I ) NX(ε ) is the supply of NX dollars to be NX 1 invested abroad. CHAPTER 6 The Open Economy 71  How ε is determined Neither S nor I ε S 1  I (r *) depends on ε, so the net capital outflow curve is vertical. ε1 ε adjusts to equate NX NX(ε ) with net capital outflow, S  I. NX NX 1 CHAPTER 6 The Open Economy 72  How ε is determined  At the equilibrium real exchange rate, the supply of dollars available from the net capital outflow balances the demand for dollars by foreigners buying this country’s net exports  At the equilibrium real exchange rate, the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports. CHAPTER 6 The Open Economy 73   We suppose the marginal propensity to consume (MPC) = 0.7 ; average production of labor (APL) = 80 ; α = 0.6 (α is the capital’s share of total income); average production of capital (APK) = 160. (we use a Cobb-Douglass production function with constant return to scale)  Compute ΔS when govt spending on goods and services (G) is increased by $250  ΔS will increase by $250  ΔS will decrease by $250  ΔS = $ 0  Further information is needed to compute ΔS CHAPTER 6 The Open Economy 74   Compute ΔS when taxes (T) are decreased by $700  ΔS will increase by $490  ΔS will decrease by $490  ΔS will decrease by $700  ΔS will increase by $700  Compute ΔS when national income (Y) is increased by $1200  ΔS will increase by $1200  ΔS will increase by $840  ΔS will decrease by $1200  ΔS will increase by $360 CHAPTER 6 The Open Economy 75   Compute ΔS when the labor (L) is decreased by 1200  ΔS will decrease by $11520  ΔS will decrease by $96000  ΔS will decrease by $38400  ΔS will decrease by $28800  Compute ΔS when the value of capital (K) is increased by $3500  ΔS will increase by $168000  ΔS will increase by $560000  ΔS will increase by $100800  ΔS will increase by $336000 CHAPTER 6 The Open Economy 76  We assume that a technological decline has affected Firms, answer questions 49 and 50 S I CHAPTER 6 The Open Economy 77   From the graph above, what is the new equilibrium point?  r*1 > r*2 and (I*1 = S*1) > (I*2 = S*2)  r*1 < r*2 and (I*1 = S*1) = (I*2 = S*2)  r*1 < r*2 and (I*1 = S*1) < (I*2 = S*2)  r*1 > r*2 and (I*1 = S*1) = (I*2 = S*2)  Following your answer to question 49, the new equilibrium situation is achieved because :  The supply of loanable funds depends on r  The supply of loanable funds is independent of r  The demand of loanable funds depends on r  The demand of loanable funds is independent of r  CHAPTER 6 The Open Economy 78