Economics 122a Open-Economy Macroeconomics Topics: 1. International issues 2. Balance of payments accounting 3. Saving and investment in the open economy 4. Determination of the exchange rate

2 What are the enduring international issues? International trade and investment increase productivity and growth (standard trade and capital theory) International competition –heightens the process of “creative destruction” –But is resisted by those why are hurt (non-standard trade theory) International spillovers (standard macro) –lead to exports and imports and affect output and employment –lead to capital flows and affect exchange rates, relative prices, interest rates, asset prices, and produces bubbles and bursts Markets cannot manage themselves. This is why nations need active rules, institutions, and policies: –Foreign economic policies on trade and finance –To coordinate policy –International institutions to help prevent destructive “prisoners’ dilemma” outcomes on trade, capital flows, war, …

World Trade and Growth in the Recession IMF, World Economics Outlook, 2010

4 What are the today’s issues? The Great Recession Fight off protectionism –Sinners are everywhere; EU threatens CO 2 trade sanctions; recent Chinese actions. Financial spillovers –Because of increasingly integrated financial markets Markets cannot manage themselves. –Coordinate risk and regulatory standards for banks (Basel III) –Contain protectionism through the WTO –Dal with exchange rate protectionism (China?)

Measuring international flows

6 Essential balancing property of Balance of Payments Current Account A Financial Account -A Net Balance 0

7 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

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

10 Overview of analysis 1.Savings-investment accounting 2.S, I, and NX determination 3.How S, I, and NX determine real exchange rate 4.Small and large open economies

11 Supply and Demand for Loanable Funds Mankiw (chap 3) shows an alternative derivation of the classical model using the loanable funds. This approach examines the sources and uses of saving and investment. Do for simplest system: Basics: (1)Y = C + I (expenditure identity) (2) S = Y - C(definition of private saving) (3)I = I(r)(investment equation) These imply : (4) S= I(r) In this alternative approach, make sure you understand the difference between the savings-investment identity and the savings- investment equilibrium.

12 Recall Closed Economy S and I equilibrium S, I Real interest rate (r) I d (r) I* r* S n = S priv + (T-G)

13 Example of disequilibrium for S and I If there is excess demand for I at r*, then the rate must rise to equilibrate S and I. This means that planned I at the original interest rate (r 0 ) was excessive. Note that equilibrating mechanism will differ in different markets – Keynesian mechanism is quantity rather than price. I(r) S(r) r r** A B r* C

14 Savings and Investment in the Open Economy ACCOUNTING: Y = output = C + I + G + NX Y = income = Y d + T + S b = C + S pers + S b + T = C + S priv + T → I + NX = S priv + S gov = S n or NX = S priv + S gov – I = S n – I

15 Classical Open Economy Equilibrium Now study open-economy equilibrium: 1. Classical economy Full employment, flex w and p; this implies that domestic output is at potential 2. Small open economy Too small to affect goods prices or financial markets 3. Mobile financial capital free flow of funds among countries Investors therefore compare domestic and foreign interest rates (r d, r w ) In small economy, r d = r w = world interest rate

16 Open Economy S and I equilibrium S, I Real interest rate (r) I d (r) I* r*=r W Net exports > 0 S n = S priv + (T-G) China, Japan, OPEC today

17 Open Economy S and I equilibrium S, I Real interest rate (r) I d (r) I* rWrW Net exports < 0 S n = S priv + (T-G) US today; LDCs classically

18 Shock I: Increase in world interest rate S, I Real interest rate (r) I d (r) I* rWrW S = S p + (T-G) rW’rW’ I** NX** NX*

19 Shock II: Increase in G S, I Real interest rate (r) I d (r) I* rWrW S** S* NX**<0 NX*>0

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

21 The Transmission Mechanism in Open Economy Macro We saw that changes in domestic saving and investment, or changes in world interest rates, or domestic risk premiums would affect net exports. How does that happen? Through the adjustment of the real exchange rate. Let see how.

Financial Globalization

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

24 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.

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

26 Real exchange rates Real exchange rate, R [Mankiw uses ε) 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

27 Big Mac Real Exchange Rate R = p d / (p f / e) Example of Big Mac* Price in Beijing: 13 Yuan Price in New York: $3.73 Real exchange rate: $3.73/(Y13/6.7) = $3.73/($1.97) = 1.89 People use this to argue that Yuan is “overvalued.” Anything wrong with this argument? *

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

We saw last time that changes in the domestic S-I balance led to changes in NX (the trade balance). We need next to understand the macroeconomic mechanism by which this occurs. We will see that this operates through changes in the real exchange rate, which leads to changes in the relative prices of foreign and domestic goods. Now to the Macroeconomic Equilibrium

30 FINANCIAL COUNTERPART of S-I balance NX = S priv + S gov – I = S n – I Net domestic saving = net foreign investment = lending abroad = ΔNFA = financial account deficit that corresponds to the current account surplus

The important condition is: NX(R) = S priv + S g – I(r w ) Note on why S does not depend upon r (but unimportant for our analysis) The only new relationship is NX(R): –Real deprecation (R ↓) lowers the price of exports in foreign markets and raises import P in domestic markets. –This raises exports and lowers imports; raising NX. –Hence NX’(R) < 0 Putting this with the S-I curves, we can see how real exchange rate is determined.

32 Net exports and the real exchange rate Real exchange rate (R) NX(R) NX 0 R* NX*

33 Savings-investment and the determination of the real exchange rate: NX(R) = S n -I(r w ) R NX(R) 0 R* NX* S n -I(r w ) E* Have two behavioral relationships: (1) NX and (2) net savings. R and NX are determined as the equilibrium of these two functions. S-I, NX

34 Why does fiscal tightening lead to a lower trade deficit?

35 Fiscal policy: G ↓ → net S ↑ → R ↓ → NX ↑ R NX(R) S-I, NX 0NX* (S-I(r w ))* E** (S-I(r w ))** NX** E* Fiscal tightening

Impact of protectionism

37 Protectionism R NX(R) S-I, NX 0NX*=NX** (S-I(r w )) R* R** NX(R)’

Macroeconomics and political upheaval

39 Political crisis and a domestic risk premium Question for class: Assume that there is a political crisis Investors now require a risk premium for investing there (relative to the rest of the world) What happens? Domestic interest rate rises above world rate by risk premium (δ). This is similar to rise in world interest rate. Investment falls and the trade account heads toward deficit. In a Keynesian world, the investment effect dominates and the country heads into recession.

Risk premiums on European debt Source: Federal Reserve, Monetary Policy Report, July Interest rate relevant for investment = Real interest rate with risk premium = Nominal risk-free rate – inflation + risk premium = i – π + δ [Interest rate relative to German debt]

41 Shock III: A Greek Tragedy S, I Real interest rate (r) I d (r d ) I* rWrW S = S p + (T-G) r d = r W + risk premium I** NX** NX*

42 The world economy before the crisis The world is a closed economy. Look at the global S-I balance using Bernanke’s theory.

Here are the basic data (pre-crisis)

Bernanke’s surprising theory of why the US deficit is so high “I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today.” (Bernanke, 2005)

45 Global savings glut: Global effect S, I Real interest rate (r) I d (r) I* r* S world ** S world * r** I**

46 From Greek tragedy to global tragedy Suppose that the world is in an equilibrium with low real interest rates and zero inflation. Then there is a big shock to investment, and the equilibrium real interest rate is very negative. Outcome: liquidity trap and the Great Recession (in the Keynesian world we will examine next week).