Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281 Macroeconomics & The global economy Ace Institute of Management Chapter 5: The open economy Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281

The International Flows of Capital and Goods Open Economy: Open to foreigners Contrary to Closed Economy: Export and Import some of its goods and services to other countries including capital mobility

Total Expenditure of an Open Economy’s Output Y = Cd + Id + Gd + EX Consumption of Domestic Goods and Services Investment in Domestic Goods and Services Govt. Purchase of Domestic Goods and Services Export of Domestic Goods and Services Foreign Spending on Domestic Goods and Services Domestic Spending on Domestic Goods and Services

Total Expenditure of an Open Economy’s Output We know that, Domestic Spending on all Goods and Services = Domestic Spending on Domestic Goods and Services + Domestic Spending on Foreign Goods and Services C = Cd +Cf or, Cd = C - Cf C = Total Consumption Cd = Consumption of Domestic goods & services Cf = Consumption of Foreign goods & services I = Id +If or, Id = I - If I = Total Investment Id = Investment in Domestic goods & services If = Investment in Foreign goods & services G = Gd +Gf or, Gd = G - Gf G = Total Govt. Purchase Gd = Govt. Purchse. of Domestic goods & services Gf = Govt. Purchse. of Foreign goods & services

Domestic spending need Total Expenditure of an Open Economy’s Output Y = (C - Cf) + (I - If) + (G - Gf) + EX Y = C + I + G + EX–(Cf+If+Gf) Expenditure on Imports Y = C + I + G + EX–IM Y = C + I + G + NX Net Exports or Trade Balance Domestic spending need not equal the Output NX= Y – (C + I + G) Net Exports = Output – Domestic Spending If Output > Domestic Spending : NX Positive: Export more If Output < Domestic Spending : NX Negative: Import more

Net Foreign Investment & the Trade Balance If, Domestic S > Domestic I, NCO is +ve ; Excess ‘S’ will be loaned out to foreigners and economy experiences Capital Outflow. If, Domestic S < Domestic I, NCO is -ve ; Deficit financing is done by borrowing from abroad and economy experiences Capital Inflow. Net Capital Outflow = Amount that Domestic residents are lending abroad – Amount that foreigners are lending to us Y = C + I + G + NX Y–C – G= I+ NX S = I+ NX S – I = NX Net Capital Outflow or Net Foreign Investment Net Exports or Trade Balance In Equilibrium, Net Capital Outflow = Trade Balance

Net Foreign Investment & the Trade Balance In Equilibrium, S – I = NX Net Capital Outflow = Trade Balance Condition of Trade Surplus: If S – I is positive, NX is positive, implies Trade Surplus Net Lender in International Financial Market Condition of Trade Deficit If S – I is negative, NX is negative, implies Trade Deficit Net Borrower from International Financial Market Condition of Balance Trade If S – I is exactly equals to NX The national income account identity shows that the international flow of funds to finance capital accumulation and the flow of goods and services are two sides of the same coin.

An Important Macroeconomic Model Relating to Saving and Investment and Trade Balance

The Model: Saving and Investment in a Small Open Economy Assumptions: Small Economy: Economy that is a small part of the world economy and can not affect the world interest rates. Perfect Capital Mobility: Country has full access to world financial markets. Domestic Interest rate (r) = World Interest Rate (r*) due to perfect capital mobility Determination of Interest Rates: Domestic : Intersection of Domestic Savings and Investment World: Intersection of World Savings and Investment

The Model More Assumptions: production function consumption function investment function exogenous policy variables

National saving: The supply of loanable funds The Model More Assumptions: r S, I National saving: The supply of loanable funds

Investment: The demand for loanable funds The Model More Assumptions: r S, I Investment: The demand for loanable funds I (r ) but the exogenous world interest rate… r * …determines the country’s level of investment. I (r* )

If the economy were closed… The Model Explanations: If the economy were closed… r S, I …the interest rate would adjust to equate investment and saving: I (r ) rc

But in a small open economy… The Model Explanations: But in a small open economy… r S, I the exogenous world interest rate determines investment… I (r ) NX r* I 1 …and the difference between saving and investment determines net capital outflow and net exports rc Case of Trade Surplus (S >I)

The Model Trade Deficit (S < I) Or, Case of Trade Deficit Explanations: r S, I I (r ) Trade Deficit (S < I) rc r* I 1

How do government policies affect Trade Balance? Three Cases: Case 1: Starting from Trade Balance, What happens if the Home Government uses expansionary fiscal polices such as increase in ‘G’ or reduce ‘T’? (Fiscal policy at home) Case 2: Starting from Trade Balance, What happens if the Foreign Government uses expansionary fiscal polices such as increase in ‘G’?(Fiscal policy abroad) Case 3: Starting from Trade Balance, What happens if the Investment increases in the home country?(An increase in investment demand)

How Policies Influence the Trade Balance? Case 1: Starting from Trade Balance, What happens if the Home Government uses expansionary fiscal polices such as increase in ‘G’ or reduce ‘T’? As we know, S = Y – C – G; When ‘G’ increases, ‘S’ decreases. As ‘T’ decreases due to tax cut, disposable income Y – T increase; Stimulate consumption and ‘C’ increases Which lowers ‘S’

Fiscal policy at home r S < I Country runs trade deficit S, I An increase in G or decrease in T reduces saving. I (r ) - NX S < I Country runs trade deficit I 1 Starting from Trade Balance, a change in fiscal policy that reduces national savings causes Trade Deficit

How Policies Influence the Trade Balance? Case 2: Starting from Trade Balance, What happens if the Foreign Government uses expansionary fiscal polices such as increase in ‘G’? Considering the foreign economy is large enough Increase in “G” by foreign government reduces world “S” and world interest rate “r*” rises. Rise in ‘r*’ increases costs of borrowing and reduces domestic “I”. Since domestic “S” has not change, S>I and some of the savings flow abroad as capital outflow. Again, as NX = S – I; NX increases as “I” decreases that leads to Trade Surplus.

Fiscal policy abroad r S > I Country runs trade surplus S, I I (r ) Expansionary fiscal policy abroad raises the world interest rate. NX2 S > I Country runs trade surplus Starting from Trade Balance, an increase in the world interest rate due to fiscal expansion abroad causes Trade Surplus

How Policies Influence the Trade Balance? Case 3: Starting from Trade Balance, What happens if the Investment increases in the home country in existing r? Increase in “I” but no change in “r*” Since “S” has not change, S<I and some of the investment has to be financed by borrowing from abroad as capital inflow. Again, as NX = S – I; NX decreases as “I” increases that leads to Trade Deficit.

An increase in investment demand S, I S I (r )2 I (r )1 I 1 - NX S < I I 2 Country runs trade deficit Starting from Trade Balance, an outward shift in the investment schedule causes Trade Deficit

Exchange Rates The exchange rate between two countries is the price at which residents of those countries trade with each other. Nominal and Real

The nominal exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Nepali Rs. 73 per US Dollar) 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.

Dollar Value of Transactions Determinants of Nominal Exchange rates Demand and Supply for the currency determines the exchange rate. Important factor: trade and Investment requirements e Dollar Value of Transactions D$ A e0 S$ $

Dollar Value of Transactions Appreciation and Depreciation Suppose there is an increase in the demand for U.S. Dollars in Nepal (for importing goods and services or going abroad). How will this affect the nominal exchange rate for US dollar in Nepal? D$ shifts rightward and increases the nominal exchange rate, e. This is known as appreciation of the dollar. e Dollar Value of Transactions D$ A e0 S$ $ D$  B e1 Events which decrease the demand for the dollar, and thus decrease e, would be a depreciation of the dollar.

Understanding Real Interest Rate A Japanese businessman thinks that Japanese cars made in the US are far better than those made in Japan. The car model he likes in Japan costs 2400,000 Japanese Yen. The existing spot (nominal) exchange rate is 120 Yen/dollar.

Understanding Real Interest Rate So, he exchanges 2400,000 Japanese Yen for $20,000 and Travels to US to buy the same car. For his surprise, the same car in US costs only $10,000. What are his impressions about the US and Japanese currencies?

Understanding Real Interest Rate Impression: Overvaluation of Japanese currency: He can buy more cars (2 cars) in US than Japan with same amount of money. The Japanese Yen is overvalued 2. Real exchange rate is different from nominal exchange rate: 1 American car = 0.5 Japanese Car (as US car costs half the price of the car in Japan). Notes for students: To judge whether a currency is overvalued, consider it from the perspective of a tourist. When the US dollar is overvalued, a US tourist traveling to Nepal will find that many products seem cheaper in Nepal than in the US, after converting at the nominal (spot) exchange rate. Thus an overvalued currency will buy more in other countries. In this respect, Nepalese currency is undervalued compared to US dollar. An undervalued currency works in the opposite direction. When the US dollar is undervalued, a US tourist traveling to Nepal will find that many products seem expensive in Nepal than in the US, after converting at the nominal (spot) exchange rate. Thus an undervalued currency will buy less in other countries. In this respect, Nepalese currency is overvalued compared to US dollar. Is over or undervaluation good or bad? That depends on who you are and what you are trying to achieve. For example, if the US dollar is overvalued with respect to Nepalese rupees, then a US tourist traveling to Nepal will be very happy. In fact, the more overvalued the dollar is, the better for him as he can stay longer in Nepal and buy many goods. Similarly, handicrafts exporters of Nepal to US will also be very happy because US importers will find Nepalese products cheaper and they will import more from Nepal. However, for an importer of US goods in Nepal, its price in Nepalese Rupees terms will be higher the more overvalued is the dollar. Thus, an overvalued dollar will likely reduce sales and profits for these firms in Nepal.

the lowercase Greek letter epsilon The real exchange rate = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. How many Nepali KFC baskets can you buy with the amount you pay for 1 U.S. KFC basket?) ε the lowercase Greek letter epsilon

e Relationship between ‘e’ and ‘e ’ Real Exchange Rate Nominal Exchange Rate at Home x Price of Domes. Goods = Price of Foreign Goods Real Exchange Rate Nominal Exchange Rate Relative Price of Goods = X P = Price of Domestic Goods P* = Price of Foreign e = e X (P / P*)

The real exchange rate with KFC Costs of KFC basket in Nepal = Rs. 900 Costs of same KFC basket in US = $10 If the nominal exchange rate is Rs. 73/dollar, What is the real exchange rate? Is Nepalese currency overvalued or undervalued compared to US currency?

The real exchange rate with KFC Costs of KFC basket in Nepal = Rs. 900 Costs of same KFC basket in US = $10 If the nominal exchange rate is Rs. 73/dollar, What is the real exchange rate? – 1.23 Is Nepalese currency overvalued or undervalued compared to US currency? - Overvalued

Relationship between NX and ε ? ε  Nepalese goods become more expensive relative to US goods  EX, IM  NX

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 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/ -4% Net exports (left scale) 40 Index -5% 20 -6% -7% 1973 1977 1981 1985 1989 1993 1997 2001 2005

The net exports function The net exports function reflects this inverse relationship between NX and ε : NX = NX(ε ) NX NX(ε ) ε 1

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,

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

Next, four applications: Impact on Real Exchange Rate due to: 1. Expansionary Fiscal policy at home 2. Expansionary Fiscal policy abroad 3. Domestic increase in investment demand 4. Trade policy to restrict imports

1. Fiscal policy at home A fiscal expansion reduces national saving, net capital outflow, and the supply of NPR against dollars in the foreign exchange market… NX 2 ε 2 ε NX NX(ε ) ε 1 NX 1 …causing the real exchange rate to rise and NX to fall.

2. Fiscal policy abroad ε 1 ε 2 NX(ε ) Expansionary Fiscal Policy abroad increases world interest rate r*, reduces investment in Nepal, increasing net capital outflow (S>I) and the supply of NPR against dollars in the foreign exchange market… ε NX NX(ε ) NX 1 ε 1 ε 2 NX 2 …causing the real exchange rate to fall and NX to rise.

3. Increase in investment demand at home An increase in investment in Nepal reduces net capital outflow (S<I) and the supply of NPR against dollars in the foreign exchange market… NX 2 ε 2 ε NX NX 1 NX(ε ) ε 1 …causing the real exchange rate to rise and NX to fall.

4. Trade policy to restrict imports At any given value of ε, an import quota  IM  NX (Note: Net Export = Export – Import) ε NX NX (ε )1 NX1 ε 1 NX (ε )2 ε 2 Trade policy doesn’t affect S or I , so capital flows and the supply of NPR against US Dollar remain fixed. Notes for Students: There are basically two explanations for this: When the Nepalese government impose import restrictions, they control import through quota or custom tariffs. As a result, Net Export increases as Net Export = Export – Import. And, NX curve shifts rightward. But, National Saving depends on savings by households and government in Nepal and Investment in Nepal depends upon world Interest rates. Since increased NX does not mean increased national saving or Investment, S-I curve remains the same. The net effect is that the real exchange rate of NPR against UD Dollar increases NX remains the same. When the government of Nepal imposes import restriction policy, the government controls imports of foreign goods. But since there is no change in export policy, export of Nepalese goods in the foreign market continues. As a result, Net Export increases in real terms. But at the same time, we can see another effect taking place in the market. Control on import will decrease the demand for US Dollar in Nepal as people have to pay less to foreigners. This will increase the exchange rate of NPR against US Dollar. The NPR becomes expensive for foreigners and they will import less from Nepal. As a result Nepalese export decreases. The net effect is that export remains the same but the real exchange rate of NPR against Dollar increases.

Purchasing Power Parity (PPP) Law of One Price: A doctrine that states that goods must sell at the same (currency-adjusted) price in all countries. The nominal exchange rate adjusts to equalize the cost of a basket of goods across countries. Reasoning: arbitrage, the law of one price

Purchasing Power Parity (PPP) PPP: e P = P* Cost of a basket of foreign goods, in foreign currency. Cost of a basket of domestic goods, in foreign currency. Cost of a basket of domestic goods, in domestic currency. Solve for e : e = P*/ P PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels. PPP implies that the cost of a basket of goods (even a basket with just one good, like a Big Mac or a latte) should be the same across countries. e P = the foreign-currency cost of a basket of goods in the U.S., while P* the cost of a basket of foreign goods. PPP implies that the baskets cost the same in both countries: eP = P*, which implies that e = P*/P.

Does PPP hold in the real world? No, for two reasons: 1. International arbitrage not possible. nontraded goods transportation costs 2. Different countries’ goods not perfect substitutes. Nonetheless, PPP is a useful theory: It’s simple & intuitive In the real world, nominal exchange rates tend toward their PPP values over the long run.

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