ECON 100 Lecture 24 Wednesday, May 7

Open Economy Macroeconomics

So far we assumed that the economy was “closed”! A closed economy does not interact with the rest of the world:

In contrast, an open economy… exports (sells) goods and services to other countries. and imports (buys) goods and services from other countries. Export = ihracat, dışsatım Import = ithalat, dışalım

An open economy also buys and sells financial assets An open economy also buys and sells financial assets* in world financial markets. An open economy lends to and borrows from the rest of the world. *Examples: cash, bank deposits, bonds, and stocks.

The world economy is becoming more open over time…

The Increasing Openness of the World Economy 1950 = 100

The world exports to GDP ratio has been increasing.

World exports to GDP, 1980-2010, Index, 2000=100 Source: IMF for world GDP, WTO Secretariat for world trade in goods and commercial services.

Turkey

Turkey has also become a more open economy exports + imports as % of GDP

Exports, imports and trade balance, 2001 - 2011 in billions of USD 230 140

Turkey, (exports by economic activities) % share in total exports, mining is on the right vertical axis

Turkey 2011 GDP ≈ $800 billion Exports = $140 billion, Imports = $230 billion. X+M/GDP ratio is about 45 %

Compared with selected countries

Imports and exports as % of GDP, selected countries, 2010

Defining X and M one more time Exports (X) (the value of) goods and services that are produced domestically (in the home country) and sold abroad. Imports (M) (the value of) goods and services that are produced abroad and sold domestically. Turkey: Export: Fındık (hazelnuts) Import: Ipad (ipad)

The trade balance, net exports, NX = X – M Net exports (NX = X – M ) are the value of a nation’s exports minus the value of its imports. Net exports are also called the trade balance, or current account balance.

Exports (X), Imports (M), Net Exports (NX) Trade deficit : Net exports are negative. NX < 0 Imports > Exports Trade surplus : Net exports are positive. NX > 0 Exports > Imports Balanced trade Net exports are zero—exports equal imports

Trade balances around the world

Recent current account figures for Turkey from TCMB (Central Bank of Turkey website)

Current account balance 2012 in millions of US$

Current account balance 2013 in millions of US$

The determinants of net exports, NX

Variables that affect NX (net exports) What happens to U.S. net exports if: A. Canada (the largest trading partner of the US) experiences an economic slowdown (recession, falling incomes, rising unemployment, etc.)?

Answers A. Canada experiences a recession U.S. net exports fall Explanation: Due to the recession and lower incomes, Canadian consumers’ purchase fewer goods and services produced in U.S.

Variables that affect NX (net exports) What happens to U.S. net exports if: B. U.S. consumers become more patriotic and buy more products “Made in the U.S.A.”?

Answers B. U.S. consumers become more patriotic and buy more products “Made in the U.S.A.” US imports fewer goods and services. U.S. net exports rise

Variables that affect NX (net exports) What happens to U.S. net exports if: C. Prices of goods produced in Mexico (the second largest trading partner of the US) rise faster than prices of goods produced in the U.S.?

Answers C. Prices of Mexican goods rise faster than prices of U.S. goods This makes U.S. goods more attractive relative to goods produced in Mexico. Exports to Mexico increase, imports from Mexico decrease, so U.S. net exports increase.

So, what is the meaning of a trade deficit, NX < 0?

Turkey, trade balance, 2001 - 2011 in billions of USD

Turkey: Savings/GDP 1980 – 2010

Start with Y = C + I + G + NX Switch the sides: C + I + G + NX = Y, and rearrange this … NX = Y – (C + I + G) NX < 0 means Y – (C + I + G) < 0 which in turn means Y < C + I + G! A trade deficit means that the country as a whole is spending beyond its current income.

Or, we can rearrange Y = C + I + G + NX as follows … Y – (C + G) = I + NX Y – (C + G) is savings. S = I + NX move I to the left: S – I = NX NX < 0 means S – I < 0 which in turn means S < I. A country that has a trade deficit means that the country is not generating enough savings to finance its investment.

How can this happen. How can one spend more than one’s income How can this happen? How can one spend more than one’s income? How can investment exceed savings?

Go into debt Borrow funds from abroad

(International) capital flows (uluslararası sermaye hareketleri) Net capital outflows (NCO) NCO = S – I ←− this is a definition NCO is the net outflow of “loanable funds” NCO can be negative, positive, or zero. When S > I, NCO > 0, the country is a net lender (borç veren) When S < I, NCO < 0, the country is a net borrower (borçlanan)

The meaning of NCO = S – I Suppose S > I The country saves more funds than its firms wish to borrow for investment. Then the excess of loanable funds will flow abroad in the form of net foreign investment (the purchase of foreign assets), and NCO > 0. Suppose S < I Firms wish to borrow more than domestic savings. Then the firms can borrow on international financial markets; in this case, there’s a net inflow of loanable funds, and NCO < 0.

Formally, NCO (net capital outflow) is defined as the domestic residents’ purchases of foreign assets minus the foreigners’ purchases of domestic assets. NCO is also called net foreign investment (NFI).

Examples for Net Capital Outflow A Turkish resident buys shares in a German company, say BMW. This purchase raises Turkey’s net capital outflow. A Japanese resident buys government bonds issued by the Turkish government. This purchase reduces the Turkish net capital outflow.

The Net Capital Outflow takes two forms The Net Capital Outflow takes two forms Foreign direct investment: Domestic residents actively manage the foreign investment, e.g., McDonalds opens a fast-food outlet in Moscow. This is an increase in the US’s NCO, in the form of a FDI. Foreign portfolio investment: Domestic residents buy foreign stocks or bonds, supplying “loanable funds” to foreign firms. 47

In class activity Please indicate how each of the following transactions affects Turkey’s NCO, net capital outflow? Is the transaction a direct investment or portfolio investment?

Turkey’s net capital outflow will increase/decrease, if… a. Akbank buys shares in South African bank Absa. b. Korean car manufacturer Hyundai expands its production facilities in Izmit. c. An American investment fund buys shares in Turkish aerospace and defense firm TAE Systems. d. Marmaris Büfe opens a branch in Caracas, Venezuela.

Answers NCO rises. Foreign portfolio investment. NCO falls. Foreign direct investment. NCO falls. Foreign portfolio investment. NCO rises. Foreign direct investment

The loanable funds market equilibrium The open economy case

The loanable funds market in a closed economy S, I the interest rate adjusts to equate investment and saving: I (r ) rc

Now consider a small open economy that can lend or borrow in international markets at world interest rate r*…

The world interest rate r The world interest rate r* is determined by saving and investment in the world loanable funds market. S* is the sum of all countries’ saving; I* the sum of all countries’ investment. r* adjusts to equate I* with S*.

A small open economy can lend or borrow in international markets at world interest rate r*… S, I the exogenous world interest rate determines investment… I (r ) NCO r* …and the difference between saving and investment determines net capital outflows rc This graph really determines net capital outflows, not NX. But, the national accounting identities say that NX = net capital outflows, so we can also write “NX” on the graph. I 1 S

The next slide shows that NX = NCO! This is very important!

The trade balance NX and net capital flows NCO Y = C + I + G + NX rearrange NX = Y – (C + I + G ) NX = (Y – C – G ) – I NX = S – I trade balance = net capital outflows A country with a trade deficit (NX < 0) is a net borrower (S < I ).

An important lesson A country (such as Turkey) that has persistent, large trade deficits (NX < 0) has low savings, relative to its investment, and is a net borrower of financial assets.

A small exercise France saves €1,000 billion and French net capital outflow is ‒€200 billion. Then, French domestic investment (I as in the GDP = C + I +G +NX) must be ‒€200 billion. €200 billion. €800 billion. €1,000 billion. €1,200 billion.

Three experiments using the loanable funds market 1. Fiscal policy at home (a change in G and/or T) 2. Fiscal policy abroad (a change in G and/or T many countries at the same time) 3. An increase in investment demand, the I(r) function shifts to the right

2. Fiscal policy abroad r S, I I (r ) Expansionary fiscal policy abroad (a decrease in G + an increase in T) will raise the world interest rate. NX2 NX1 Results: The world interest rate r* is determined by saving and investment in the world loanable funds market. S* is the sum of all countries’ saving; I* the sum of all countries’ investment. r* adjusts to equate I* with S*. A fiscal expansion in other countries would reduce S* and raise r* (same results as in chapter 3). The higher world interest rate reduces investment in our small open economy, and hence reduces the demand for loanable funds. The supply of loanable funds (national saving) is unchanged, so there’s an increase in the amount of funds flowing abroad.

End of the lecture