Principles of Economics Session 15

Topics To Be Covered Open and Closed Economies Flow of Goods and Capital Equality of Net Exports and Net Foreign Investment Nominal and Real Exchange Rate Purchasing Power Parity Theory The Market for Loanable Funds

Topics To Be Covered The Market for Foreign-Currency Exchange Marginal Propensity to Import Output Determination in Open Economy Balance of Payments BP Curve IS-LM-BP Model Monetary and Fiscal Policies in Open Economy

Open and Closed Economies A closed economy is one that does not interact with other economies in the world. There are no exports, no imports, and no capital flows. An open economy is one that interacts freely with other economies around the world.

An Open Economy An open economy interacts with other countries in two ways. It buys and sells goods and services in world product markets. It buys and sells capital assets in world financial markets.

The Flow of Goods Exports are domestically produced goods and services that are sold abroad. They mainly depend on exchange rates. EX = f (e) Imports are foreign produced goods and services that are sold domestically. They mainly depend on output. IM = f (Y)

The Flow of Goods Net exports (NX) are the value of a nation’s exports minus the value of its imports. Net exports are also called the trade balance.

The Flow of Goods A trade deficit is a situation in which net exports (NX) are negative. Imports > Exports A trade surplus is a situation in which net exports (NX) are positive. Exports > Imports Balanced trade refers to when net exports are zero – exports and imports are exactly equal.

The Internationalization of the Chinese Economy Percent of GDP 50 40 30 20 10 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

The Flow of Capital Net foreign investment refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. A Chinese resident buys stock in the Toyota corporation and an American buys stock in the Sohu corporation.

The Flow of Capital When a Chinese resident buys stock in IBM, the purchase raises Chinese net foreign investment. When a Japanese resident buys a bond issued by the Chinese government, the purchase reduces the Chinese net foreign investment.

The Equality of NX and NFI Net exports (NX) and net foreign investment (NFI) are closely linked. For an economy as a whole, NX and NFI must balance each other so that: NFI = NX This holds true because every transaction that affects one side must also affect the other side by the same amount.

Saving, Investment, and the International Flows Net exports is a component of GDP: Y = C + I + G + NX National saving is the income of the nation that is left after paying for current consumption and government purchases: Y - C - G = I + NX

Saving, Investment, and the International Flows National saving (S) equals Y-C-G so: S = I + NX or Domestic Investment Foreign Investment Saving = +

Real and Nominal Exchange Rates International transactions are influenced by international prices. The two most important international prices are the nominal exchange rate and the real exchange rate.

Nominal Exchange Rates The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. The nominal exchange rate is expressed in two ways: In units of foreign currency per one Chinese yuan. And in units of Chinese yuan per one unit of the foreign currency.

Nominal Exchange Rates Assume the exchange rate between the U.S. dollar and the Chinese yuan is one dollar to 8 yuan. One U.S. dollar trades for 8 yuan. One yuan trades for 1/8 (=0.125) of a dollar.

Nominal Exchange Rates If one yuan buys more foreign currency, there is an appreciation of the yuan. If it buys less there is a depreciation of the yuan.

Real Exchange Rates The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies.

Real Exchange Rates Real Exchange Rate The real exchange rate is a key determinant of how much a country exports and imports.

Real Exchange Rates A depreciation (fall) in the Chinese real exchange rate means that Chinese goods have become cheaper relative to foreign goods. This encourages consumers both at home and abroad to buy more Chinese goods and fewer goods from other countries.

Real Exchange Rates As a result, Chinese exports rise, and Chinese imports fall, and both of these changes raise Chinese net exports. Conversely, an appreciation in the Chinese real exchange rate means that Chinese goods have become more expensive compared to foreign goods, so Chinese net exports fall.

Purchasing-Power Parity The purchasing-power parity theory (PPP theory) is the simplest and most widely accepted theory explaining the variation of currency exchange rates. According to the purchasing-power parity theory, a unit of any given currency should be able to buy the same quantity of goods in all countries.

Basic Logic of Purchasing-Power Parity The theory of purchasing-power parity is based on a principle called the law of one price. According to the law of one price, a good must sell for the same price in all locations.

Basic Logic of Purchasing-Power Parity If the law of one price were not true, unexploited profit opportunities would exist. The process of taking advantage of differences in prices in different markets is called arbitrage.

Basic Logic of Purchasing-Power Parity If arbitrage occurs, eventually prices that differed in two markets would necessarily converge. According to the theory of purchasing-power parity, a currency must have the same purchasing power in all countries and exchange rates move to ensure that.

Implications of Purchasing-Power Parity If the purchasing power of is always the same at home and abroad, then the exchange rate cannot change. The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries.

Implications of Purchasing-Power Parity When the central bank prints large quantities of money, the money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.

Limitations of Purchasing-Power Parity Many goods are not easily traded or shipped from one country to another. Tradable goods are not always perfect substitutes when they are produced in different countries.

Fixed vs. Floating Exchange Rates A country has a fixed exchange rate if it pegs its currency at a given exchange rate and stands ready to defend that rate. Exchange rates which are determined by market supply and demand are called flexible exchange rates or floating exchange rates.

The Market for Loanable Funds The market for loanable funds (capital market) is one in which those who want to save supply funds and those who want to borrow to invest demand funds. It is the market in which financial resources (money, bonds, stocks) are traded.

The Market for Loanable Funds S = I + NFI At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net foreign investment.

The Market for Loanable Funds The supply of loanable funds comes from national saving (S). The demand for loanable funds comes from domestic investment (I) and net foreign investment (NFI).

The Market for Loanable Funds The supply and demand for loanable funds depend on the real interest rate. A higher real interest rate encourages people to save and raises the quantity of loanable funds supplied. The interest rate adjusts to bring the supply and demand for loanable funds into balance.

The Market for Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Demand for loanable funds (for domestic investment and net foreign investment) Equilibrium quantity real interest rate Quantity of Loanable Funds

The Market for Loanable Funds At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment.

The Market for Foreign-Currency Exchange The two sides of the foreign-currency exchange market are represented by NFI and NX. NFI represents the imbalance between the purchases and sales of capital assets. NX represents the imbalance between exports and imports of goods and services.

The Market for Foreign-Currency Exchange In the market for foreign-currency exchange, the Chinese yuan is traded for foreign currencies. For an economy as a whole, NFI and NX must balance each other out, or: NFI = NX

The Market for Foreign-Currency Exchange The price that balances the supply and demand for foreign-currency is the real exchange rate.

The Market for Foreign-Currency Exchange The demand curve for foreign currency is downward sloping because a higher exchange rate makes domestic goods more expensive. The supply curve is vertical because the quantity of dollars supplied for net foreign investment is unrelated to the real exchange rate.

The Market for Foreign-Currency Exchange Real Exchange Rate Supply of RMB (from net foreign investment) Demand for RMB (for net exports) Equilibrium quantity Equilibrium real exchange rate Quantity of RMB Exchanged into Foreign Currency

The Market for Foreign-Currency Exchange The real exchange rate adjusts to balance the supply and demand for RMB. At the equilibrium real exchange rate, the demand for RMB to buy net exports exactly balances the supply of RMB to be exchanged into foreign currency to buy assets abroad.

Marginal Propensity to Import The marginal propensity to import (MPm) refers to the increase in the dollar value of imports resulting from each dollar increase in the value of GDP.

Output Determination in Open Economy Expenditure 45° Output=Expenditure C = a + bY Slope(E1 )=b E1 =C(Y) +I (r )+G E2 =C(Y) +I(r )+G-IM(Y） IM = mY Y1 E2 = a +I+G+(b-m)Y Y2 Slope(E2 )=b-m Output

Output Determination in Open Economy Expenditure 45° Output=Expenditure E2 =C(Y) +I(r )+G + EX(e) -IM(Y） E1 =C(Y) +I(r )+G-IM(Y） 1. An increase in export… Y2 2. …leads to an increase in output Slope=b-m Y1 Output

Equilibrium Output in Open Economy Planned aggregate expenditure in an open economy equals: In equilibrium:

The Open Economy Multiplier b = MPC m = MPm 1 – b + m = 1 – MPC + MPm = MPS +MPm The multiplier is:

The Open Economy Multiplier The multiplier in the closed economy is: The multiplier in the open economy is:

The Balance of Payments The balance of payment is a statement showing all of a nation’s transactions with the rest of the world for a given period. It includes purchases and sales of goods and services, gifts, government transactions, and capital movements.

The Balance of Payments Suppose the initial international transaction was that a Chinese company exported a plane to the U.S. for $100 million. The Chinese central bank bought $10 million for CNY 80 million. What was Chinese balance of payments like for that year?

The Balance of Payments Debit Credit Current Account Export 100,000,000 Import Balance on current account Capital Account Private 90,000,000 Official Reserves 10,000,000 Balance on capital account

The Balance of Payments Net Debits (-) or Credits (+) Current Account Export 100,000,000 Import Balance on current account Capital Account Private －90,000,000 Official Reserves －10,000,000 Balance on capital account － 100,000,000 Statistical Discrepancy Balance of Payments

The Balance of Payments United States Balance of Payments, 1999 (in billion dollars) CURRENT ACCOUNT (1) Net export of goods – 347.2 (2) Net export of services 79.6 (3) Net investment income – 24.7 (4) Net transfer payments – 46.6 (5) Balance on current account (1 + 2 + 3 + 4) – 338.9 CAPITAL ACCOUNT (6) Change in private U.S. assets abroad (increase is –) – 381.0 (7) Change in foreign private assets in the United States 706.2 (8) Change in U.S. government assets abroad (increase is –) 8.3 (9) Change in foreign government assets in the U.S. 44.5 (10) Balance on capital account (6 + 7 + 8 + 9) 378.0 STATISTICAL DISCREPENCY – 39.1 BALANCE OF PAYMENTS (5 + 10 + 11)

The Balance of Payments A country’s current account is the sum of its: net exports (exports minus imports), net income received from investments abroad, and net transfer payments from abroad. Exports earn foreign exchange and are a credit (+) item on the current account. Imports use up foreign exchange and are a debit (–) item.

The Balance of Payments The balance of trade is the difference between a country’s exports of goods and services and its imports of goods and services. A trade deficit occurs when a country’s exports are less than its imports.

The Balance of Payments Investment income consists of holdings of foreign assets that yield dividends, interest, rent, and profits paid to U.S. asset holders (a source of foreign exchange). Net transfer payments are the difference between payments from the United States to foreigners and payments from foreigners to the United States.

The Balance of Payments The balance on current account consists of net exports of goods, plus net exports of services, plus net investment income, plus net transfer payments. It shows how much a nation has spent relative to how much it has earned. For each transaction recorded in the current account, there is an offsetting transaction recorded in the capital account.

The Balance of Payments The capital account records the changes in assets and liabilities. The balance on capital account in the United States is the sum of the following (measured in a given period): the change in private U.S. assets abroad the change in foreign private assets in U.S. the change in U.S. government assets abroad the change in foreign government assets in U.S.

The Balance of Payments In the absence of errors, the balance on capital account would equal the negative of the balance on current account. If the capital account is positive, the change in foreign assets in the country is greater than the change in the country’s assets abroad, which is a decrease in the net wealth of the country.

The BP Curve The BP curve is a graph of all combinations of interest (r) and output (Y) that result in foreign exchange market equilibrium.

Net Foreign Investment Deriving the BP Curve Net Foreign Investment The BP Curve r r BP Curve NFI2 Y2 r2 E2 E2 r1 r1 E1 E1 NFI Y NFI1 Y1

Deriving the BP Equation n =marginal propensity to import e =real exchange rate g＞ 0, n ＞ 0, m ＞ 0 r* =foreign interest rate r =domestic interest a ＞ 0

Deriving the BP Equation

Interest rate increases Deriving the BP Curve An increase in income (GDP) increases the import, decreases the net export, in turn decreases NFI. NFI decrease is responsive to a higher interest. GDP increases Import increases NX decreases NFI decreases Interest rate increases

The BP Curve r BP Surplus BP＞0 BP A B C BP Deficit BP＜0 D F G IS Y

The BP Curve If there exists an BP surplus, the supply of foreign currencies is greater than the demand for them. Foreign currencies are likely to depreciate, while the domestic currency tends to appreciate. If there exists an BP deficit, the demand for foreign currencies is greater than the supply. Foreign currencies are likely to appreciate, while the domestic currency tends to depreciate.

Exchange Rate and BP Curve Changes BP(e1) Lower exchange rate moves the BP curve rightward BP(e2) Y

Equilibrium interest rate The IS-LM-BP Model r LM BP Equilibrium interest rate E Equilibrium output IS Y

The IS-LM-BP Model r LM IS2 BP1 BP2 E2 Y2 r2 r1 E1 IS1 Y Y1

The IS-LM-BP Model At E1, both the goods market and money market are in equilibrium, but the foreign exchange market is not, for BP is of deficit. The demand for foreign exchange is greater than the supply. The domestic currency will depreciate. The BP curve tends to move downward The depreciation of domestic currency will lead to more NX, thus driving the IS curve rightward. Finally the three markets reach an equilibrium at E2.

Fiscal Policy and IS-LM-BP in Floating Exchange Rate Context

Fiscal Policy and IS-LM-BP in Floating Exchange Rate Context An expansionary fiscal policy moves the IS curve rightward, and the goods market and money market is in equilibrium at E2. At E2, there exists BP surplus in the foreign exchange market, the domestic currency tends to appreciate. The appreciation will decrease the NX, and thus pushing IS curve leftward until E3.

Fiscal Policy and IS-LM-BP in Floating Exchange Rate Context In the open economy, the expansionary fiscal policy has crowding-out effect not only on the domestic investment, but on net export. Therefore, the multiplier effect of expansionary fiscal policy is not significant. In Japan, for example, the multiplier is estimated to be only 1.2.

Monetary Policy and IS-LM-BP in Floating Exchange Rate Context

Monetary Policy and IS-LM-BP in Floating Exchange Rate Context If the central bank effects an expansionary monetary policy, the LM curve moves to the right. The goods market and money market are of equilibrium at E2, but the foreign exchange market faces a BP deficit—demand for foreign currency is greater than supply. The domestic currency tends to depreciate, which moves the BP curve downward.

Monetary Policy and IS-LM-BP in Floating Exchange Rate Context The depreciation of domestic currency encourages export, thus moving the IS curve rightward. The open economy equilibrate at E3. In the open economy, the monetary policy is very effective.

Fiscal Policy and IS-LM-BP in Fixed Exchange Rate Context

Fiscal Policy and IS-LM-BP in Fixed Exchange Rate Context Suppose the government adopts an expansionary policy, the IS curve moves rightward. At E2, the goods and money markets reach an equilibrium, but the foreign exchange market does not. There exists the BP surplus. As a result, the domestic currency depreciate.

Fiscal Policy and IS-LM-BP in Fixed Exchange Rate Context Since the rates between currencies should remain fixed, the central bank is obliged to buy foreign currencies. The purchase of foreign currencies increases the supply of domestic currency, shifting the LM curve right. Fiscal policies in the fixed exchanged foreign rate context are effective.

Monetary Policy and IS-LM-BP in Fixed Exchange Rate Context

Monetary Policy and IS-LM-BP in Fixed Exchange Rate Context If the central bank increases its money supply, the LM curve shifts right. At E2, the goods and money market are of equilibrium, while the foreign exchange market isn’t, for there exists an BP deficit. The strong demand for foreign currencies will lead to the depreciation of domestic currencies.

Monetary Policy and IS-LM-BP in Fixed Exchange Rate Context To keep the fixed exchange rates constant, the central bank has to sell foreign currencies it holds as reserves. The selling of foreign currencies means the reduction of money supply, this will bring back the LM curve. So monetary policies in the open economy is of little or even no effect.

Assignment Review Chapter 31 and 34 What are the benefits and harms of keeping the Chinese currency from depreciation during the Asian financial crises? (Group work)

Revision for the Final Exam Review the whole book. Answer multiple-choice questions in your handouts. Pay special attention to the following questions: 58—4 58—6 78—1 79—7 130—6 153—2 153—8 169—2 169—6 186—1 187—9 206—9 224—3 264—1

Revision for the Final Exam How is China’s GDP in recent years and its prospect in the future? Discuss China’s fiscal and monetary policies. How are China’s price level and employment in recent years? What measures has the government taken to improve them?

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