Chapter 5 The Open Economy MACROECONOMICS Chapter 5 The Open Economy

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Imports and Exports As a Fraction of GDP Imports and exports as a percentage of GDP by country, 2000. Source: OECD

Trade Balance ≈ Capital Flows A positive trade balance (trade surplus) happens when national saving exceeds investments. A trade deficit indicates that investments are greater than national savings. A trade surplus means there is a capital outflow. A trade deficit means there is a capital inflow. If domestic spending (C+I+G) is less than the GDP (Y), then net exports will be positive. If domestic spending exceeds Y then there will be a trade deficit.

US Current Account and Net Foreign Wealth, 1977–2003

http://www.clevelandfed.org/research/trends/2009/0909/ET_sep09.pdf p.9

Why NX is Capital Outflow? You import a DVD of Japanese anime by using your debit card. The Japanese producer of anime deposits the funds in its bank account in San Francisco. The bank credits the account by the amount of the deposit. (Capital inflow = -NX) A tourist from Detroit buys a meal in France and pays with a traveler’s check. (Capital inflow = -NX) An Italian buys a Dell computer and pays by a credit card issued by an Italian bank. (Capital outflow = NX)

Is US a Small Country? US has the largest GDP in the world with one-fifth of the income, one-seventh of the imports, and one tenth of the exports of the world. A large country is one that can affect export or import prices by its supply or demand. Most economists assume that is true of US. Using an industrial organization approach, Christopher Magee and Stephen Magee (Review of International Economics, 16(5), 990-1004, 2008) show that US is a small country.

Smallness and Capital Flows If capital markets in the world are free then any one can borrow in the world market and any one can lend in the world market. If borrowers or lenders (however they are categorized) are small, then the world real interest rate will equate the demand and supply of loanable funds in the world. World saving=World investment and r=r*

S, I, NX in Small Open Economies Circular flow makes GDP=Income. This equality shows that national saving will be equal to investment plus net exports. Or national saving minus investment equals net exports. In the classical approach, labor and capital markets are in equilibrium (no unemployment) so the K and L are given in the production function, which makes Y fixed. Since consumption is determined through Y, once Y is fixed so is C and SHH. If investments are determined by r*, then the difference between S and I will be NX.

GDP HOUSEHOLDS FIRMS C FINANCIAL SYSTEM Spri I EX IM T TR+INT Y=wages+salaries+rent+profits+interest C FINANCIAL SYSTEM Spri I EX IM T TR+INT REST OF THE WORLD GOVERNMENT NX>0 -Sfor -Sgov NX<0 Sfor T>TR+INT+G :Sgov G

S, I, and NX S r S-I=NX gets different values for different real interest rate for the world. At r** the interest rate would be the same as the closed economy interest rate. NX>0 r*** NX=0 r** r* I NX<0 I,S What would happen to this diagram (1) when expansionary fiscal policy is pursued? (2) when new savings enter the world capital markets? (3) when investment at home increases? (4) when world investment increases?

Is Trade Deficit Bad? If it is the result of low national savings, then the future generations will have to pay in lower consumption. If it is the result of high investment, future income will be higher to compensate for the interest on the debt.

Why Doesn’t Capital Flow to Poor Countries? MPK is higher when K is lower. But poor countries might have other limitations reducing A, hence lowering Y. Infrastructure Court system Corruption Undefined, unreliable property rights

Exchange Rate Nominal Exchange Rate ¥/$ or $/€ Real Exchange Rate (¥/$)(PUS/PJ) ε = e (P/P*) ($/€)(PEU/PUS) Suppose 100 ¥=1$, 2$=1€, an average American car is $20,000, Japanese car is ¥1,000,000, German car is €15,000. The meaning of Real Exchange Rate in terms of cars; in general.

NX and ε When the real exchange rate (ε) is high domestic goods are more expensive compared to foreign goods. NX goes down. NX = NX (ε) ε = (EUR/USD)(Pus/Peu) ε NX

Determination of ε S-I>0 S-I<0 ε S-I=0 NX(ε) +NX -NX

Policies and ε Expansionary fiscal policy at home S down => r up => ε up => NX down Expansionary fiscal policy abroad World savings down => r* up => S-I up => ε down => NX up Investment tax credit at home I up => r up => ε up => NX down Protectionist policies NX shifts right (more NX at same ε) => ε up but no change in NX because S-I did not change

Nominal Exchange and Inflation Nominal exchange rate times price ratios equal real exchange rate. Nominal exchange rate equals real exchange rate times price ratios (observe which country’s price level is in the numerator and which in the denominator). Percentage change in nominal exchange rate equals percentage change in the real exchange rate + percentage change in the abroad price level – percentage change in the home price level. Ceteris paribus, if inflation at home is larger than abroad, then the nominal exchange rate should depreciate. If abroad inflation is higher than home, nominal exchange rate should appreciate.

Law of One Price Tradable goods should have the same price because of arbitrage. Apply the same principle and you get real exchange rate of one. Not even Big Macs follow the law of one price.

2009 http://www.economist.com/markets/indicators/displaystory.cfm?story_id=13055650