Ohio Wesleyan University Goran Skosples 6. The Open Economy

accounting identities for the open economy the small open economy model what makes it “small” how the trade balance and exchange rate are determined how policies affect trade balance & exchange rate

Key Concepts Net exports Trade balance Capital mobility Net capital outflow Small open economy World interest rate Nominal exchange rate Real exchange rate Purchasing power parity Trade policy Large open economy

Imports and exports of selected countries, 2011 In dollar terms, U.S. trade is huge, but as a percentage of GDP, it is smaller than that of many other countries. source: World Development Indicators, World Bank http://databank.worldbank.org/ddp/home.do?Step=3&id=4

In an open economy, spending need not equal _______ saving need not equal ___________ EX = exports = foreign spending on domestic goods IM = imports = domestic spending on foreign goods NX = net exports (a.k.a. the “trade balance”) = EX – IM

The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G ) net exports trade surplus: output __ spending and EX __ IM trade deficit: spending __ output and IM __ EX

International capital flows Net capital outflow = S – I = net outflow of “loanable funds” = net purchases of foreign assets the country’s purchases of foreign assets minus foreign purchases of domestic assets When S > I, country is a _________ When S < I, country is a ____________

The link between trade & cap. flows NX = Y – (C + I + G ) implies NX = = Thus, a country with a trade deficit (NX < 0) is a net ____________ (S < I ).

Saving, investment, and the trade balance 1960–2013 Notice that investment > saving pretty consistently beginning in the early 1980s. The trade balance is measured on the right-hand scale; note that the location of 0% is different on the two scales. source: Federal Reserve Bank of St. Louis notes: Investment was constructed as the sum of Gross Private Domestic Investment (GPDI), Federal Government Defense Investment (DGI), Federal Government Nondefense Investment (NDGI), and State & Local Investment (SLINV). Saving is simply Gross Saving (GSAVE). The Trade Balance was constructed as saving minus investment. trade balance (right scale)

Saving and investment in a small open economy An open-economy version of the loanable funds model from Chapter 3. Includes many of the same elements: production function consumption function investment function exogenous policy variables

National saving: The supply of loanable funds r S, I As in Chapter 3, national saving ____ ____depend on the interest rate

Assumptions re: Capital flows a. domestic & foreign bonds are perfect ________ (same risk, maturity, etc.) b. perfect capital _________: no restrictions on international trade in assets c. economy is ______: cannot affect the world interest rate, denoted r* a & b imply _____ c implies r* is __________

Investment: The demand for loanable funds Investment is still a _________-sloping function of the interest rate, r S, I but the exogenous world interest rate… …determines the country’s level of ___________.

If the economy were closed… S, I I (r )

Point Trade balance is determined by saving and investment at the world interest rate. r* r S, I I (r ) I (r ) r S, I r* when S I the country ____ K ___ the rest of the world when S __ I the country ______ K ____ the rest of the world

Three experiments: Fiscal policy at home Fiscal policy abroad An increase in investment demand

1. Fiscal policy at home r S, I I (r ) An increase in G or decrease in T _______ saving. I (r ) Results:

NX and the federal budget deficit (% of GDP), 1965–2013 Budget deficit (left scale) Our model implies a negative relationship between NX and the budget deficit. We observe this negative relationship during most periods. There are some exceptions. For example, from 1991 to 2001, NX and the budget deficit fell, due to a long expansion: rising incomes increased imports and tax revenues. And, in 2008-2009, NX and the budget deficit rose as the economy faltered: falling incomes reduce both tax revenue and imports. Source: Department of Commerce. Obtained from: http://research.stlouisfed.org/fred2/ Net exports (right scale)

2. Fiscal policy abroad r S, I I (r ) Expansionary fiscal policy abroad _____ the world interest rate. NX1 Results:

3. An increase in investment demand S, I S ANSWERS: I , S , net capital outflow and NX ________ ___________ ___________ I (r )1 I 1 NX1

Two exchange rates e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar) ε = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac)

Understanding the units of ε

~ McZample ~ one good: Big Mac price in Japan: P* = 200 Yen price in USA: P = $2.50 nominal exchange rate e = 120 Yen/$ To buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy __ Japanese Big Macs. 22

The net exports function How NX depends on ε ε  U.S. goods become more expensive relative to foreign goods  EX, IM  NX The net exports function The net exports function reflects this inverse relationship between NX and ε : NX =

U.S. net exports and the real exchange rate, 1973–2012 Trade-weighted real exchange rate index (March 1973 = 100) (% of GDP) NX Index Net exports (left scale) The real exchange rate here is a broad index. Source: Federal Reserve Statistical Release H.10, Board of Governors. http://www.federalreserve.gov/releases/h10/summary/indexbc_m.txt 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/ The RER data are monthly and the NX and Y data are quarterly, so the RER series shown in the graph is a quarterly series where each value is an average of the three monthly values from that quarter.

The NX curve for the U.S. NX ε NX (ε)

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

How ε is determined Neither S nor I depend on ε, so the net capital outflow curve is _____. ε NX NX(ε ) ε 1 ε adjusts to ________ NX with net capital outflow, _____.

Four experiments: Fiscal policy at home Fiscal policy abroad An increase in investment demand Trade policy to restrict imports

1. Fiscal policy at home ↑ G  ε NX NX(ε ) ε 1 NX 1

2. Fiscal policy abroad ↑ G abroad  ε NX NX(ε ) NX 1 ε 1

3. Increase in investment demand  ε NX NX 1 NX(ε ) ε 1

4. Trade policy to restrict imports At any given value of ε, an import quota  IM  NX  demand for dollars _____ ______ ε NX NX (ε )1 NX1 ε 1 Trade policy ______ affect S or I , so capital flows and the supply of dollars ____________.

The determinants of the nominal exchange rate Start with the expression for the real exchange rate: Solve for the nominal exchange rate: 33

The determinants of the nominal exchange rate So e depends on the real exchange rate and the price levels at home and abroad… …and we know how each of them is determined: 34

The determinants of the nominal exchange rate Rewrite this equation in growth rates (recall “arithmetic tricks for working with % changes”) For a given value of ε, the growth rate of e equals the difference between ____________________________. 35

Inflation differentials and nominal exchange rates for a cross section of countries % change in nominal exchange rate Iceland Pakistan Mexico U.K. S. Africa Sweden S. Korea Japan Denmark Figure 6-13 on p.158. The horizontal axis measures the country’s inflation rate minus the U.S. inflation rate. The vertical axis measures the percentage change in the U.S. dollar exchange rate with that country (positive values mean the country’s currency depreciates relative to the dollar). All variables are annual averages over the period 2001-2010. This figure shows a positive relationship between the inflation differential and the rate of dollar appreciation: The higher a country’s inflation relative to U.S. inflation, the faster the U.S. dollar will appreciate against that country’s currency. Source: International Financial Statistics Note: Due to space constraints on this slide, Norway’s point is not labeled; it is virtually identical to Canada’s point. Canada Singapore Australia Switzerland New Zealand inflation differential

Purchasing Power Parity (PPP) If international arbitrage is possible, then $ must have the same purchasing power in every country __ equalizes purchasing power: Does PPP hold in the real world? No entirely, for two reasons: International arbitrage not possible. Goods of different countries not __________ ________________. Why is PPP then important?

CASE STUDY: The Reagan deficits revisited closed economy small open economy actual change ε NX I r S G – T 1980s 1970s 115.1 -0.3 19.9 1.1 19.6 2.2 129.4 -2.0 19.4 6.3 17.4 3.9   Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index. 38

The U.S. as a large open economy So far, we’ve learned long-run models for two extreme cases: closed economy (chap. 3) small open economy (chap. 5) A large open economy – like the U.S. – falls ___________ these two extremes. The results from large open economy analysis are a ___________ of the results for the closed & small open economy cases. For example… 39

A fiscal expansion in three models A fiscal expansion causes national saving to fall. The effects of this depend on openness & size: NX I r large open economy small open economy closed economy 40

Net exports--the difference between exports and imports a country’s output (Y ) and its spending (C + I + G) Net capital outflow equals purchases of foreign assets minus foreign purchases of the country’s assets the difference between saving and investment National income accounts identities: Y = C + I + G + NX trade balance NX = S - I net capital outflow

Impact of policies on NX : NX increases if policy causes S to rise or I to fall NX does not change if policy affects neither S nor I. Example: trade policy Exchange rates nominal: the price of a country’s currency in terms of another country’s currency real: the price of a country’s goods in terms of another country’s goods. the real exchange rate equals the nominal rate times the ratio of prices of the two countries.

How the real exchange rate is determined NX depends negatively on the real exchange rate, other things equal The real exchange rate adjusts to equate NX with net capital outflow