Chapter 5 The Open Economy (Continued) CHAPTER 5 The Open Economy

Small Open Economy Model A small economy: The country is small in the sense that it takes the world interest rate (r*) as given. We relax the assumption that domestic real interest rate is determined when S = I In fact S >< I How is the world real interest rate determined? Sworld = Iworld CHAPTER 5 The Open Economy

When r*>rc S>I: Net Capital outflow, KA deficit, CA surplus (=Trade surplus) CHAPTER 5 The Open Economy

When rc >r*,I>S, Net capital inflow, KA surplus, CA deficit (=trade deficit) S, I I (r ) rc r* Trade deficit CHAPTER 5 The Open Economy

Three experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand In the textbook, NX = 0 in the economy’s initial equilibrium for each of these three experiments. In these slides, NX > 0 in the initial equilibrium. For completeness, you might have your students repeat the three experiments for the case of NX < 0 in the initial equilibrium. This would be a good homework or in-class exercise. CHAPTER 5 The Open Economy

1. Fiscal Policy at Home Last time we considered this experiment for r*>rc as the starting point Try the same experiment for: r*=rc r*<rc For all the alternative starting points, you should reach the same conclusion: Expansionary fiscal policy reduces NX. Starting from a balanced trade, it becomes negative Starting from a trade deficit, the deficit widens Contractionary fiscal policy increases NX CHAPTER 5 The Open Economy

Suppose there is expansionary FP by a large country  ↓ world savings 2. Fiscal policy abroad Suppose there is expansionary FP by a large country  ↓ world savings What happens to world interest rate? Think of the world as a closed economy CHAPTER 5 The Open Economy

World Interest Rate r S, I r2* r1 I (r ) I 1 S CHAPTER 5 The Open Economy

What happens at home? r S, I I (r ) Expansionary fiscal policy abroad raises the world interest rate. NX2 NX1 Results: It might be worth taking a moment to explain that 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*, just like in Chapter 3, because the world as a whole is a closed economy. 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. CHAPTER 5 The Open Economy

Try this experiment for the following starting points: r*=rc r*<rc CHAPTER 5 The Open Economy

3. An increase in investment demand S, I S I (r )1 I 1 NX1 EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. Have students get out a piece of paper, draw this graph on it, and then do the analysis. A couple minutes should suffice. It might be useful to have them compare their answers with the results from the closed economy case. CHAPTER 5 The Open Economy

3. An increase in investment demand S, I S I (r )2 I (r )1 NX2 ANSWERS: ΔI > 0, ΔS = 0, net capital outflow and NX fall by the amount ΔI I 1 NX1 I 2 In contrast to a closed economy, investment is not constrained by the fixed (domestic) supply of loanable funds. Hence, the increase in firm’s demand for loanable funds can be satisfied by borrowing abroad, which reduces net outflow of financial capital. And since net capital outflow = NX, we see a fall in NX equal to the increase in investment. CHAPTER 5 The Open Economy

As I ↑ for a given S, S – I declines the increase in I is financed by lending less to foreigners Net capital outflow shrinks (Capital account deficit gets smaller) Trade surplus shrinks Or, if you had started with a trade deficit (i.e. r*<rc), the deficit worsens CHAPTER 5 The Open Economy

Evaluating Economic Policy What would a large trade deficit in a country suggest? Is it due to low S (bad) or high I (good). What can a government do to ↓ trade deficit? Contractionary FP. Why is this difficult? CHAPTER 5 The Open Economy

The nominal exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Dollar per Lira) Warning to students: Some textbooks and newspapers define the exchange rate as the reciprocal of the one here (e.g., dollars per yen instead of yen per dollar). The one here is easier to use, because a rise in “e” corresponds to an “appreciation” of the country’s currency. Using the reciprocal would mean that a rise in “e” is a depreciation, which seems counter-intuitive. So it would be worthwhile to point out to students that a country’s “e” is simply the price (measured in foreign currency) of a unit of that country’s currency. CHAPTER 5 The Open Economy

Example The exchange rate between USD and TL is: A Turk needs to pay 1.40 TL for each USD he/she buys. An American needs to pay e=1/1.40=$ 0.70 per 1 YL In this example, the nominal exchange rate is e=0.70 (value of TL in $) CHAPTER 5 The Open Economy

Turkey: Nominal Exchange Rate (1 Dolar + 1 Euro) vs 1 TL

the lowercase Greek letter epsilon The real exchange rate = real exchange rate, the relative price of the goods of two countries (i.e. rate at which we can trade the goods of one country with the goods of another). Also called terms of trade. (e.g. US Big Macs per Turkish Big Mac) ε the lowercase Greek letter epsilon CHAPTER 5 The Open Economy

Example Price of a suit in Turkey/Price of a suit in US = Real exchange rate Suppose a suit costs you 500 TL in Turkey and $1000 in US. We need to express both suits in the same currency: say $ Real exchange rate CHAPTER 5 The Open Economy

More formally: For a broader basket of goods: CHAPTER 5 The Open Economy

Example one good: Big Mac price in USA: P* = $2.50 price in Turkey: P = 7.20 TL nominal exchange rate e = 0.70 $/TL Price of Big Macs in Turkey are about twice as much as the price in the US. CHAPTER 5 The Open Economy slide 20

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 A good candidate for the basket of goods mentioned here is the CPI basket. Perhaps a better candidate would be a basket including all goods & services that comprise GDP. Then, the real exchange rate would measure how many units of foreign GDP trade for one unit of domestic GDP. CHAPTER 5 The Open Economy

Turkey: Real Effective Exchange Rate (1995=100)

How NX depends on ε ↑ ε  Domestic goods become more expensive relative to foreign goods  ↓EX, ↑ IM  ↓NX It is important to think of epsilon as the ratio of domestic goods and foreign goods. Domestic goods are converted to foreign currency via the nominal exchange rate in the numerator. CHAPTER 5 The Open Economy

U.S. net exports and the real exchange rate, 1973-2006 3% Trade-weighted real exchange rate index 140 2% 120 1% 100 0% -1% (March 1973 = 100) 80 (% of GDP) -2% 60 -3% NX -4% Net exports (left scale) The real exchange rate here is a broad index. Source: Federal Reserve Statistical Release H.10, Board of Governors. (To find it, simply google “Federal Reserve Statistical Release H.10”) NX as a percent of GDP was computed from NX and GDP source data from Department of Commerce, Bureau of Economic Analysis, obtained at: http://research.stlouisfed.org/fred2/ 40 Index -5% 20 -6% -7% 1973 1977 1981 1985 1989 1993 1997 2001 2005 CHAPTER 5 The Open Economy

The net exports function The net exports function reflects this inverse relationship between NX and ε : NX = NX(ε ) CHAPTER 5 The Open Economy

The NX curve ε ε1 so our net exports will be high NX ε NX (ε) NX(ε1) so our net exports will be high ε1 When ε is relatively low, our goods are relatively inexpensive Notice that the NX curve is drawn such that it incorporates positive and negative values all in the first quadrant CHAPTER 5 The Open Economy

The NX curve ε2 At high enough values of ε, domestic goods become so expensive that NX ε NX (ε) NX(ε2) we export less than we import CHAPTER 5 The Open Economy

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 In the equation, ε is the only endogenous variable, hence this equation determines the value of ε. CHAPTER 5 The Open Economy