ECO 102: Macroeconomic Theory of the Open-Economy

ECO 102: Principles of Economics – II Topic 9: A Macroeconomic Theory of the Open-Economy Dr. Chandril Bhattacharyya Department of Economic Sciences IISER Bhopal Goal of the model: To highlight forces that determine trade balance and exchange rate Loo...

ECO 102: Principles of Economics – II Topic 9: A Macroeconomic Theory of the Open-Economy Dr. Chandril Bhattacharyya Department of Economic Sciences IISER Bhopal Goal of the model: To highlight forces that determine trade balance and exchange rate Look simultaneously at two related markets: i) Market for loanable funds ii) Market for foreign currency exchange We assume i) Real GDP (Y) of the country is given. As it is determined by supply of factors and level of technology. ii) Price level given, determined by money demand and supply. Market for Loanable Funds: All savers and all borrowers go there. In an open economy - S = I + NX = I + NCO - Saving = Domestic investment + Net capital outflow Loanable funds – interpreted as - Domestically generated flow of resources available for capital accumulation Purchase of a capital asset - Adds to the demand for loanable funds Supply of loanable funds - From national saving (S) Demand for loanable funds - From domestic investment (I) - And net capital outflow (NCO) Market for Loanable Funds When NCO > 0 - Net outflow of capital - Net purchase of capital overseas o Adds to the demand for domestically generated loanable funds When NCO < 0 - Net inflow of capital - Capital resources coming from abroad o Reduce the demand for domestically generated loanable funds Market for Loanable Funds - Asset located at home: I - Asset located abroad: NCO Higher real interest rate - Encourages people to save o Increases quantity of loanable funds supplied - Discourages investment o Decreases quantity of loanable funds demanded - Discourages residents of home country from buying foreign assets o Reduces net capital outflow - Encourages foreigners to buy assets of home country o Reduces net capital outflow Market for Loanable Funds Supply of loanable At equilibrium interest funds upward sloping rate - Encourages people to save - Amount people want to save Demand of loanable - Exactly balances the desired quantities of domestic funds investment and net capital - Slopes downward outflow The Market for Loanable Funds The interest rate in an open economy, as in a closed economy, is determined by the supply and demand for loanable funds. National saving is the source of the supply of loanable funds. Domestic investment and net capital outflow are the sources of the demand for loanable funds. At the equilibrium interest rate, the amount that people want to save exactly balances the amount that people want to borrow for the purpose of buying domestic capital and foreign assets. Foreign-Currency Exchange The market for foreign- foreign assets currency exchange o Capital is flowing abroad, NCO > 0 - Identity: NCO = NX - Net Capital outflow = Net If trade deficit, exports NX < 0 If trade surplus, - Imports > Exports NX > 0 - Some of this spending is - Exports > Imports financed by selling domestic assets abroad - Net sale of goods and o Foreign capital is flowing servcies abroad into home country, NCO < 0 - Domestic citizens use the foreign currency to buy Foreign-Currency Exchange Supply of foreign- - Net exports currency exchange o Quantity of dollars - Net capital outflow demanded to buy U.S. net exports of goods and o Quantity of dollars services supplied to buy foreign assets - Demand curve is downward sloping - Supply curve is vertical o Quantity of dollars - A higher real exchange supplied for net capital rate outflow o Making U.S. goods more o Does not depend on the expensive. So EX falls and real exchange rate IM goes up. o Reduces the quantity of - Demand for foreign- dollars demanded to buy currency exchange those goods and services. Why doesn’t Net capital outflow depend on real exchange rate (RER)? As RER is high, then a domestic resident can buy more foreign assets. But people invest in assets to sell it and earn profit. When they will sell, the return will not be more when converted into domestic currency as RER is high. The dividend of Bond will also will not be high as converted value will be less. So RER doesn’t impact NCO. Foreign-Currency Exchange Equilibrium The Market for Foreign-Currency Exchange real exchange rate - Demand for dollars o By foreigners o Arising from U.S. net exports of goods and services - Exactly balances The real exchange rate is determined by the supply and demand for foreign- supply of dollars currency exchange. The supply of dollars to be exchanged into foreign currency comes from net capital outflow. Because net capital outflow does not o From Americans depend on the real exchange rate, the supply curve is vertical. The demand for dollars comes from net exports. Because a lower real exchange rate stimulates o Arising from U.S. net exports (and thus increases the quantity of dollars demanded to pay for these net exports), the demand curve is downward sloping. At the equilibrium net capital ouflow 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. Note that we are assuming NCO generates supply of domestic currency & NX generates demand of domestic currency If NCO rises (falls) => domestic currency depreciates (appreciates) We can also view NCO generates demand for foreign currency (to buy foreign assets) & NX generates supply for foreign currency (to buy goods and services produced in home country) So NCO rise => foreign currency appreciates (domestic currency depreciates) Equilibrium in the Open Economy Identities How Net Capital Outflow Depends on the Interest Rate - Market for loanable funds: S = I + NCO - Market for foreign- currency exchange: NCO = NX Net-capital- outflow curve - Link between o Market for loanable funds Because a higher domestic real interest rate makes domestic assets more attractive, it reduces net capital outflow. Note the position of zero on the o Market for foreign- horizontal axis: Net capital outflow can be positive or negative. A negative value of net capital outflow means that the economy is experiencing a net currency exchange inflow of capital. Equilibrium in the Open Economy Market for loanable funds - Supply: national saving - Demand: domestic investment and net capital outflow - Equilibrium real interest rate, r Net capital ouflow - Slopes downward - Equilibrium real interest rate, r Market for foreign currency exchange - Supply: net capital outflow - Demand: net exports - Equilibrium real exchange rate, E - As we assumed prices are given, so equilibrium nominal exchanged rate is also determined. (RER = [e.P] / P*) Equilibrium in the Open Economy Equilibrium real E and r adjust interest rate, r simultaneously - Price of goods and - To balance supply and services in the present demand o Relative to goods and - In both markets services in the future o Loanable funds Equilibrium real o Foreign-currency exchange rate, E exchange - Determine - Price of domestic goods and services o National saving o Relative to foreign goods o Domestic investment and services o Net capital ouflow o Net exports Equilibrium in the Open Economy The Real Equilibrium in an Open Economy In panel (a), the supply and demand for loanable funds determine the real interest rate. In panel (b), the interest rate determines net capital outflow, 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. Government Budget Deficits Government budget deficits - When government spending exceeds government revenue - Negative public saving - Reduces national saving - Reduces supply of loanable funds - Increase in interest rate - Reduces net capital ouflow - Crowd-out domestic investment - Decrease in supply of foreign-currency exchange - Currency appreicates - Net exports fall - Push the trade balance toward deficit Government Budget Deficits The Effects of a Government Budget Deficit When the government runs a budget 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 capital outflow. Reduced net capital outflow, 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. Government Budget Deficits In earlier chapter, we studied that when Government deficit is high, then NX will be low from S = I + NX equation. In this chapter we learned a channel (by increase in r and fall in NCO) through which this can hold. If budget deficit causes Trade deficit, then they are called Twin deficit. However, there can be other causes of Trade deficit other than budget deficit. Trade Policy Trade policy - Government policy - Directly influences the quantity of goods and services o That a country imports or exports - Tariff: tax on imports - Import quota: limit on quantity of imports - Voluntary export restrictions Macroeconomic impact of trade policy - Decrease imports (Suppose due to Quota, it seems that it will improve trade deficit) - Increase in net exports - Increase in demand for dollars in the market for foreign- currency exchange Trade Policy - Real exchange rate appreciates o Discourage exports - No change in real interest rate - No change in net capital outflow - No change in net exports as (NX = NCO = S – I) o Decrease in imports o Decrease in exports - Trade policies do not affect the trade balance (surprising conclusion). (note that we assumed Y, P, P* given and E flexible) - Trade policies affect specific firms o Firms o Industries o Countries Trade Policy The Effects of an Import Quota When the U.S. government imposes a quota on the import of Japanese cars, nothing happens in the market for loanable funds in panel (a) or to net capital outflow 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. Political Instability and Capital Flight Political instability o Sell Mexican assets o Buy U.S. assets, “safe - Leads to capital flight haven” Capital flight - Mexico’s Net-capital- - Large and sudden outflow increases reduction in the demand o Supply of pesos in the for assets located in a market for foreign- country currency exchange – increases Mexico - capital flight affects both markets - 1994, political instability - Investors – capital flight o Demand curve in the towards surplus market for loanable funds - U.S. market increases o Fall in U.S. net capital - Interest rate in Mexico – outflow increases o The dollar appreciates in o Reduce domestic value investment o U.S. interest rates fall o Slows capital o Relatively small impact accumulations on the U.S. economy – o Slows economic growth because the economy of - The peso depreciates the United States is so o Exports – cheaper large compared to that of Mexico o Imports – more expensive o Trade balance moves Political Instability and Capital Flight The Effects of Capital Flight If people decide that Mexico is a risky place to keep their savings, they will move their capital to safer havens such as the U.S., resulting in an increase in Mexican net capital outflow. 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 capital outflow is higher for any interest rate, that curve also shifts to the right from NCO1 to NCO2 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. Capital Flows from China to USA: Chinese Government accumulates foreign assets, including US government Bonds. NCO from China increases => Supply of Chinese currency increases => its value depreciates EX of China gets help from that => more employment. US NCO decreases => $ appreciates => US Trade balance worsens But US r falls, and boosts investment. In total: China sacrifices its own consumption and domestic investment but generates job. US domestic investment gets better but trade deficit. Americans get cheaper Chinese product. Thank You !