1 Finish savings experiment Thoughts on sources of technological change Real business cycles: A sketch Open economy macroeconomics International financial system Short-run open-economy output determination (Mundell - Fleming model) The rise, crisis, and (fall?) of the Euro Open-economy macroeconomics

2 Bottom line this week Exports and imports affect aggregate demand, particularly for very open economies. Openness is growing in trade and finance. Exchange rates are the monetary link among countries. In the open economy, the tail wags the dog (tail = financial flows; dog = trade balance). US has a chronic trade surplus because people love to put their money here (central banks and investors). Countries face a trilemma among fixed exchange rates, domestic monetary policy, and open financial markets. Europe has made a fateful choice in the trilemma that is devastating the continent with no end in sight.

3 New elements in open-economy macro 1.Trade flows: -Exports and imports depend on relative prices (domestic to foreign) -These depend critically on exchange rate: NX(R) = EX(R) – IM(R); NX’(R) < 0. 2.Financial capital increasingly “mobile” –Free flow of finance among countries –Investors compare domestic and foreign interest rates (r d, r w ) –Capital outflow (CF) = lending abroad = CF(r d, r w ). –In small economy, r d = r w = world interest rate (riskless)

4 Measuring international flows

5 Essential balancing property of Balance of Payments Current Account (≈NX)A Financial Balance (≈-CF) -A Net Balance 0 For macro purposes: Net exports = capital outflow NX = CF

6 Balance of Payments v. Real Goods and Services 1.Macro: NX = Net Exports = exports goods and services – imports g&s 2. Current account: Current account = NX + locational adjustments (domestic v. national product) + unilateral transfers (not current goods/services) Difference = locational stuff + transfers

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8 Globalization in trade of goods and services, US Rising trend

9 Open Economy Macro: The transmission mechanism through the real exchange rate

10 Exchange rates Foreign-exchange rates are the relative prices of different national monies or currencies. Convention in Econ 122 and Jones: Nominal exchange rate Exchange rates = amount of foreign currency per unit of domestic currency. Think Japanese Yen: 100 yen to $.

11 Terminology For market-determined exchange rates: An appreciation of a currency is when the value of the currency rises –e or R rises A depreciation of a currency is when the value of the currency falls –e or R falls For fixed exchange rates: Price set by government is the “parity.” A revaluation is an increase in the official parity. A devaluation is a decrease in the parity.

12 Index of US nominal exchange rate (e) Appreciation Depreciation

13 Real exchange rates Real exchange rate, R [Jones uses RER) R = nominal exchange rate corrected for relative prices R = e × (p d / p f ) = p d / (p f / e) = domestic prices/foreign prices in a common currency Note: If you calculate the rate of growth of R, you get Example of car exchange rate: 100 Yen/$; Toyota = 2,000,000Y; Ford = $20,000; R = 100 * 20000/ = 1 Toyota/Ford

14 Big Mac Real Exchange Rate R = p d / (p f / e) Example of Big Mac Price in Beijing: 15.4Yuan Price in New York: $4.20 Real exchange rate: $4.20/(Y15.4/6.32) = $4.07/( $3.67) = 1.72 People use this to argue that Yuan is 72% “undervalued.” Anything wrong with this argument?

15 Real exchange rate of $ relative to major currencies (R) Appreciation Depreciation

16 Dollar bubble: high $ interest rates Internet bubble Flight to safety in $ Real exchange rate of $ relative to major currencies (R) Appreciation Depreciation

17 Short run or long run? (full adjustment of capital, expectations, etc.) Classical or non-classical? (sticky wages and prices, rational expectations, etc.) long- run short- run yes Keynesian model (sticky wages and prices, upward-sloping AS Tree of Macroeconomics Closed economy IS-MP, dynamic AS-AD Open economy Mundell-Fleming model no

18 The Mundell-Fleming Model for Open Economy Mundell-Fleming (MF) model is short run Keynesian model for open economy. Very similar to IS-MP model. It derives impact of policies and shocks in the short run for an open economy. Usual stuff for domestic sectors: -Price and wage stickiness, unemployment, no inflation -Standard determinants for domestic industries (C, I, G, financial markets, etc.) Open economy aspects: -Small open economy would have r d = r w -Large open economy financial flows (CF) determined by r d and r w -Net exports a function of real exchange rate, NX = NX(R)

19 Goods market Start with usual expenditure-output equilibrium condition. New wrinkle is the NX function: (1) Y = C(Y - T) + I(r d ) + G + NX(R) Financial markets Then the monetary policy equation. (2) r = L (Y) Balance of Payments Capital flows are determined by domestic and foreign interest rates. But have BP balance: (3) CF(r d, r w ) = NX(R) Substituting (3) into (1), we get equation in Y and r d which is IS$ curve. (IS$) Y = C(Y - T) + I(r d ) + G + CF(r d, r w )

20 Dollars out = debit - I buy VW - Yale buys Greek debt. CF > 0 (outflow) Dollars in = credit - Marco comes to Yale. - Worry warts buy T bills. CF < 0 (capital inflow

21 A picture album of the world economy, 2012

22 The output decline in the Great Recession Percent change from prior year All from the IMF, World Economic Outlook, Sept 2012.

23 Unemployment during the Great Recession Percent of labor force

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27 The growth in the public debt around the world Debt/GDP ratio (%)

28 CF rdrd MP$ C+I(r d )+G+CF(r d ) (IS$) CF Y CF=NX=0 C+I(r d )+G (IS) Equilibrium Open Economy

29 Special Case I. Stimulus plan How does openness change the impact of a stimulus plan? Multiplier is reduced because some of the stimulus spills into imports and stimulates other countries Note that financial crisis and high risk premium is the opposite (IS$ shift to the left)

30 CF rdrd MP$ IS$ CF Y (S$’ Open economy Closed economy IS IS’ Fiscal Expansion

31 Special Case II. Normal Monetary Expansion How does openness change the impact of a monetary policy? Double barreled effect of monetary policy -Lower r → higher I (domestic investment) -Lower r → higher CF → depreciates exchange rate (R) → raises NX (foreign investment)

32 CF rdrd MP$ IS$ CF Y MP$’ IS Monetary Expansion Open economy Closed economy

33 Special Case III What about a liquidity trap? Note that monetary policy cannot work on either of the two mechanisms in a liquidity trap. -Interest rates stuck and cannot stimulate domestic investment. -With no change in interest rates, no change in CF (financial flows), no change exchange rate, no change NX So open economy does not change the basic liquidity trap dilemma!

34 CF rdrd MP$ CF Y IS$ Equilibrium MP$’ Monetary Expansion in Liquidity Trap

35 CF rdrd MP$ CF Y IS$ Equilibrium You do fiscal expansion

36 The International Monetary System

37 What is the international monetary system? International monetary system denotes the institutions under which payments are made for transactions that cross national boundaries and are made in different currencies. In particular, the international monetary system determines how foreign exchange rates are set and how governments can affect exchange rates.

38 I.. Fixed exchange rate A. Currency union: currencies irrevocably fixed - US states ( ) - Eurozone (2001- ?) B. Other fixed exchange rate regimes: –Gold standard ( ) –Bretton Woods ( ) II. Flexible exchange rates -Currencies are market determined -Governments use monetary policies to affect exchange rates Exchange rate regimes

39 What are desirable characteristics of an international financial system? 1.Stability of exchange rates to lower risk and promote trade and capital flows. 2.Openness of financial markets to promote efficient allocation and diffusion of best-practice technologies 3.Adjustment to macroeconomic shocks through monetary policy But we will see that these three goals are not compatible in the “fundamental trilemma”

40 The share of floating has increased sharply (% of world GDP)

41 The Fundamental Trilemma Country can choose only two the three objectives: fixed exchange rate, open financial markets, or monetary independence: 1.Country can have fixed exchange rate and retain monetary policy. But this would require maintaining controls on financial flows. - China today and early Bretton Woods; 2. Country can leave financial movements free and retain monetary autonomy, but only by letting the exchange rate fluctuate. - Euro countries and US 3. Country can have open financial markets and stabilize the currency, but only by abandoning monetary policy as countercyclical tool. - Argentina yesteryear, individual countries of Euroland, Hong Kong

42 History of Eurozone -Gold standard through 1914, suspended WW I, reinstates 1920s. -Long war (1914 – 1945) followed by political union after Gold standard deepened the Great Depression -Reconstruction with Bretton Woods system ( ) -Common Market and European Community (1958 – 1993) -European Monetary System ( ): fixed rates of major countries -Delors plan for monetary union (1989) -Irrevocable fixing of rates for Eurozone (2001) -Full establishment (1999) and adopted by 17 countries as of Growing imbalances after World financial crisis 2008 weakened public finances -Eurozone crisis begins in Ireland, spreads to Greece, then to Italy -According to Euroskeptics, the end of the Eurozone is nigh…

43 Eurozone 2012

44 Major “flow” problem: no way to adjust to imbalances which lead to changes in real exchange rate (R)

45 r Euro IS$(2000) CF Y 2000 IS$(2010) Y 2010 Y 2012 r Euro + risk premium Greece, Spain, Italy: The Sweet Life Turns Sour

46 Options according to Nouriel Roubini* 1.Rapid Growth of Eurozone –ECB lowers rates, Euro depreciates, Germany expands –Problem: No way Germany will allow 2. Long Recession to Restore Periphery Competitiveness. -Austerity in periphery -Problem: No way citizens of Greece, Italy, etc. will put up with 3. The Core Permanently Subsidizes the Periphery (“transfer union”) - Problem: No way Germany will subsidize Greece and Italy 4. Widespread Debt Restructurings and EZ breakup -Default? -Problem: will lead to world financial meltdown. * Former Yale Department of Economics Professor.