ECON 100 Lecture 23 Monday, May 6

Open-Economy Macroeconomics

So far we assumed that the economy was “closed”! A closed economy does not interact with the rest of the world: Exports = 0, Imports = 0. Export = ihracat, dışsatım Import = ithalat, dışalım

In contrast, an open economy… exports (sells) goods and services to other countries. and imports (buys) goods and services from other countries. 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.

The world economy is becoming more open over time…

The Increasing Openness of the World Economy 1950 = 100

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

Turkey: Imports and exports 1980 – 2011 in billions of USD

Turkey has become an open economy over time exports + imports as % of GDP

The last 10 years… 2001 - 2011

Exports and imports as % of GDP, 2001 - 2011

Trade balance, 2001 - 2011 in billions of USD

How does that compare with the rest of the world?

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

A few definitions that everybody already knows Exports (X) (the value of) goods and services that are produced domestically and sold abroad. Imports (M) (the value of) goods and services that are produced abroad and sold domestically. Turkey: Export: Fındık Import: Ipad

Turkey, exports

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, Imports, Net Exports 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 and imports are exactly equal.

Most recent current account figures from TCMB

Current account balance 2012 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 Because, due to the recession and lower incomes, Canadian consumers’ purchase fewer goods and services produced in U.S. U.S. net exports rise

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 rearrange this … NX = Y – (C + I + G) NX < 0 means Y – (C + I + G) < 0 which in turn means C + I + G > Y. 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 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? Borrow some funds?

(International) capital flows (uluslararası sermaye hareketleri) Net capital outflows (NCO) NCO = S – I NCO is the net outflow of “loanable funds” When S > I, NCO > 0, country is a net lender (borç veren) When S < I, NCO < 0, 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 a government bond 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. Foreign portfolio investment: Domestic residents buy foreign stocks or bonds, supplying “loanable funds” to foreign firms. 41

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?

a. Akbank buys shares in South African bank Absa. b 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

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 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 ).

A very important lesson A country (such as Turkey) that has persistent, large trade deficits (NX < 0) also has low saving, 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 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 2. Fiscal policy abroad 3. An increase in investment demand

2. Fiscal policy abroad r S, I I (r ) Expansionary fiscal policy abroad raises 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.