economics 101_lecture 14_open economy

8/3/2019 Economics 101_Lecture 14_Open Economy

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Economics 101: Lecture 14 The

Open Economy

Outline

Measuring international flows of goods andcapital

Determining the trade balance

Exchange rate determination


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In an open economy, a countrys spending neednot equal its output of goods and services

Spend more and borrow from abroad

Spend less and lend to abroad

International flows of capital and

goods

International flows of capital andgoods

EX= exports =

foreign spending on domestic goodsIM= imports = Cf+If+ Gf

= spending on foreign goods

NX= net exports (a.k.a.the trade balance)

=EXIM

superscripts:

d = spending ondomestic goods

f = spending onforeign goods


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GDP = expenditure on domesticallyproduced g & s

d d dY C I G EX

( ) ( ) ( )f f fC C I I G G EX

( )f f fC I G EX C I G

C I G EX IM

C I G NX

International flows of capital and goods

The national income identity in an openeconomy

Y= C+I+ G+NX

or, NX= Y (C + I + G)

net exports

domesticspending

output



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Trade surpluses and deficits

trade surplus:output > spending and exports > importsSize of the trade surplus =NX

trade deficit:spending > output and imports > exportsSize of the trade deficit = NX

NX = EXIM = Y (C + I + G)


Saving and Investment in a Small Open

Economy

Net capital outflows

= S I

= net outflow of loanable funds

= net purchases of foreign assets

the countrys purchases of foreign assetsminus foreign purchases of domestic assets

WhenS >I, country is a net lender

WhenS


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The link between trade & capital flows

NX = Y (C +I + G)

implies

NX = (Y C G) I

= S I

trade balance = net capital outflows

Thus,

a country with a trade deficit (NX< 0)

is a net borrower (S< I).


Economy

Saving and Investment in a Small OpenEconomy

An open-economy version of the loanable fundsmodel from chapter 3.

Includes many of the same elements:


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National Saving: The Supply of Loanable Funds

r

S, I

As in Chapter 3,national saving doesnot depend on theinterest rate

( )S Y C Y T G

S

Assumptions re: capital flows

a. domestic & 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 &b imply r= r*

c implies r* is exogenous


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Investment: The Demand for Loanable Funds

Investment is still adownward-sloping function

of the interest rate,

r*

but the exogenousworld interest rate

determines thecountrys level of

investment.

I(r*)

r

S, I

I(r)

If the economy were closedr

S, I

I(r)

S

rc

( )c

I r

S

the interestrate wouldadjust toequateinvestment

and saving:


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But in a small open economy

r

S, I

I(r)

S

rc

r*

I1

the exogenousworld interestrate determinesinvestment

and thedifferencebetween savingand investmentdetermines netcapital outflowsand net exports

NX


Economy Thus, the trade balance depends on fiscal policy

and world interest rates


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Effects of policies

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

1. Fiscal policy at home

r

S, I

I(r)

I1

An increase in Gor decrease in Treduces saving.

1

*r

NX1

2S

NX2

Results:

0I

0NX S


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r

S, I

I(r)

1SExpansionaryfiscal policyabroad raisesthe worldinterest rate

.

1

*r

NX1

NX2

Results:

0I 0NX I

2

*r

1( )*I r

2( )*I r

3. An increase in investment demandr

S, I

I(r)1

I > 0,S = 0,net capitaloutflows andnet exportsfall by theamount I

NX2

NX1

*r

I1 I2

S

I(r)2


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The nominal exchange rate

e = nominal exchange rate, the relative

price of domestic currency in terms of

foreign currency (e.g. Foreign currency

per Domestic currency)


The real exchange rate

= real exchange rate,

the relative price of domestic

goods in terms of foreign goods

(e.g. US Big Macs per

Philippines Big Mac)

the lowercaseGreek letter

epsilon



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=( foreign currency per domestic currency *domestic currency per unit of domestic good) /foreign currency per unit of foreign good

=( foreign currency per unit of domestic good) /

foreign currency per unit of foreign good

=units of foreign good/unit of domestic good


In the real world:

We can think of as the relative price of

a basket of domestic goods in terms of a basket

of foreign goods

In our macro model:Theres just one good, output.

So is the relative price of one countrys

output in terms of the other countrys output


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How NXdepends on

domestic goods become moreexpensive relative to foreign goods

EX, IM NX

The net exports function

The net exports function reflects this

inverse relationship betweenNXand :

NX =NX()


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The NXcurve for the home country

0 NX

NX()

1

When isrelatively low,domesticgoods are

relativelyinexpensive

NX(1)

so home netexports willbe high

The NXcurve for the home country

0 NX

NX()

2

At high enoughvalues of,domestic goodsbecome soexpensive that

NX(2)

we export

less thanwe import


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How is determined

The accounting identity saysNX=SI

We saw earlier howSI is determined:

S depends on domestic factors (output,fiscal policy variables, etc)

I is determined by the world interestrate r*

So, must adjust to ensure

How is determined

NeitherSnorI

depend on ,

so the net capital

outflow curve is

vertical.

NXNX()

1 ( *)S I r

adjusts to

equate NX

with net capital

outflow, SI.

1

NX1


16/23


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1. Fiscal policy at homeA fiscal expansion

reduces nationalsaving, net capitaloutflows, and thesupply of domesticcurrencies in theforeign exchangemarket

causing the

real exchangerate to rise and

NX to fall.

NXNX()

1 ( *)S I r

1

NX1NX2

2 ( *)S I r

2


An increase in r*reduces investment,increasing net capitaloutflows and thesupply of domesticcurrencies in theforeign exchange

market

causing the

real exchange

rate to fall and

NX to rise.

NXNX()

1 1( *)S I r

NX1

1

21 ( )*S I r

2

NX2


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3. An increase in investment demand

An increase ininvestmentreduces netcapital outflowsand the supplyof domesticcurrencies in theforeign exchangemarket

NXNX()

causing thereal exchange

rate to rise and

NX to fall.

1

1 1S I

NX1

21S I

NX2

2

slide 36

4. Trade policy to restrict imports

NXNX()1

S I

NX1

1

NX()2

At any given value of, an import quota

IM NX

demand forDomestic

currencies shifts

right

Trade policy doesnt

affect Sor I, so

capital flows and the

supply of Domestic

currencies remains

fixed.

2


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slide 37

4. Trade policy to restrict imports

NXNX()1

S I

NX1

1

NX()2

Results: > 0

(demandincrease)

NX = 0(supply fixed)

IM< 0(policy)

EX< 0(rise in )

2

The Determinants of the Nominal ExchangeRate

Start with the expression for the realexchange rate:

Solve it for the nominal exchange rate:


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The Determinants of the Nominal ExchangeRate

( * , )M

L r YP

( ) ( )*NX S I r

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

and we know how each of them isdetermined:

*P

e P

*

* *

*( * *, )

ML r Y

P

The Determinants of the NominalExchange Rate

We can rewrite this equation in terms ofgrowth rates

*P

e P

*

*

e P P

e P P *

For a given value of,the growth rate ofe equals the differencebetween foreign and domestic inflation rates.


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Purchasing Power Parity (PPP)

Two definitions:

a doctrine that states that goods must sell at thesame (currency-adjusted) price in all countries.

the nominal exchange rate adjusts to equalize thecost of a basket of goods across countries.

Reasoning:

arbitrage, the law of one price

Purchasing Power Parity (PPP) PPP: e P =P*

Cost of a basket of

domestic goods, in

foreign currency.

Cost of a basket of

domestic goods, in

domestic currency.

Cost of a basket of

foreign goods, in foreign

currency.

Solve for e: e = P*/P

PPP implies that the nominal exchange ratebetween two countries equals the ratio ofthe countries price levels.


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Purchasing Power Parity (PPP) Ife =P*/P,

then*

* *1P P P e

P P P

and the NX curve is horizontal:

NX

NX = 1

SI Under PPP, changes in (SI) have no impact on or

e.

Does PPP hold in the real world?No, for two reasons:

1. International arbitrage not possible.

nontraded goods

transportation costs

2. Goods of different countries not perfectsubstitutes.

Nonetheless, PPP is a useful theory:

Its simple & intuitive

In the real world, nominal exchange rates havea tendency toward their PPP values over thelong run.


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The Balance of Payments

The Balance of Payments

The Big Mac Index

The Big Mac Index
http://concepts%20and%20definitions.pdf/http://concepts%20and%20definitions.pdf/

economics 101_lecture 14_open economy

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