The Open Economy in the Long Run

1
The Open Economy in the Long Run

• Chapter 5

2
The Open Economy

• Assume small, open economy
• Small means price taker
• Measure of openness
• Trade relative to GDP

3
Imports and Exports as a percentage of output
2004
4
Trade-GDP ratio, selected countries,
2004(Imports Exports) as a percentage of GDP
5
Good and Capital Flows

• Good and capital flows related
• C Cd Cf
• I Id If
• G Gd Gf
• EX exports of domestic goods services
• GDP equals
• Y (C - Cf) (I If) (G Gf) EX
• or
• C I G EX (Cf If Gf)
• or
• Y C I G EX IM

6
Net Exports and Domestic Spending

• Net exports
• NX EX IM
• Net exports domestic output domestic spending
• NX Y - (C I G)
• For Y gt C I G, NX gt 0
• For Y lt C I G, NXlt0

7
U.S. Net Export Position
8
Net Foreign Investment

• Trade balance and net foreign investment
• Y C G I NX
• National saving is Y C G
• S I NX
• or
• S I NX
• S I is net foreign investment
• NX is trade balance
• For S gt I, a trade surplus (NXgt0), and net
  foreign investment is positive
• For SltI, a trade deficit (NXlt0), and net foreign
  investment is negative

9
Saving and investment in a small, open economy

• Small - country does not affect world economy
• Perfect capital mobility
• World real interest rate, r
• Domestic real interest rate
• r r
• World interest rate determined by world S and I
• Small country cannot affect r

10
Model

• Y Y F(K,L)
• C C(Y T)
• I I(r) I(r)
• NX (Y C G) I
• NX S I
• NX S I(r)
• Saving affect by fiscal policy, G and T
• I determined by world interest rate

11
But in a small open economy
the exogenous world interest rate determines
investment
NX
and the difference between saving and investment
determines net capital outflows and net exports
12
Domestic and Net Foreign Investment

• NX depends upon fiscal policy and r
• NX depends on difference between S and I
• Fiscal expansion, increase G or decrease T
• National saving falls, causing trade deficit

13
Domestic fiscal policy
An increase in G or decrease in T reduces saving.
14
The twin deficits

• How close are trade and budget deficits?
• Does budget deficit cause trade deficit?

15
NX and the federal budget deficit ( of GDP),
1960-2006
4
8
6
2
Trade
4
0
2
-2
0
-4
Net Exports (left scale)
-2
-6
-4
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
16
Fiscal policy abroad

• Assume increase in G abroad that increases r
• Higher r reduces domestic I and increases NX

17
Fiscal policy abroad
Expansionary fiscal policy abroad raises the
world interest rate.
Results
18
Increased Domestic Investment

• Policy to increase I - investment tax credit
• Result is decrease NX, trade deficit

19
An increase in investment demand
ANSWERS ?I gt 0, ?S 0, net capital outflows
and net exports fall by the amount ?I
20
Are trade deficits bad?

• Developing nations often have trade deficits that
  allow a higher level of I
• Preference for US assets can cause trade deficit
• What is effect of U.S. international borrowing on
  developing nations?

21
Exchange rates

• Nominal exchange rate value of one currency in
  terms of another currency
• Real exchange rate relative price of goods in
  two countries

22
A few exchange rates, as of 7/14/06
23
Relating real and nominal exchange rates

• e nominal exchange rate (foreign currency price
  of )
• ? real exchange rate
• P/P ratio of price levels (domestic to
  foreign)
• ? e x P/P
• Cost of imports varies inversely with real rate 
• Trade balance varies inversely with real exchange
  rate

24
The NX curve for the U.S.
25
The NX curve for the U.S.
26
U.S. net exports and the real exchange rate,
1973-2006
3
140
2
120
1
100
0
-1
(March 1973 100)
80
( of GDP)
-2
60
-3
NX
-4
40
Index
-5
20
-6
-7
0
1973
1977
1981
1985
1989
1993
1997
2001
2005
27
Determination of Real Exchange Rate

• NX NX(?)
• NX S I
• NX(?) S I(r)
• Both S and I are independent of ?
• Real exchange rate, ?, adjusts to equate NX with
  S - I

28
How e is determined

• Neither S nor I depend on e, so the net capital
  outflow curve is vertical.

e 1
e adjusts to equate NX with net capital
outflow, S - I.
NX 1
29
Fiscal policy at home

• A fiscal expansion reduces national saving, net
  capital outflows, and the supply of dollars in
  the foreign exchange market

causing the real exchange rate to rise and NX
to fall.
30
Fiscal policy abroad

• An increase in r reduces investment, increasing
  net capital outflows and the supply of dollars in
  the foreign exchange market

causing the real exchange rate to fall and NX
to rise.
31
An increase in investment demand

• An increase in investment reduces net capital
  outflows and the supply of dollars in the
  foreign exchange market

causing the real exchange rate to rise and NX
to fall.
32
Trade policy to restrict imports

• At any given value of e, an import quota
• ? ?IM ? ?NX
• ? demand for dollars shifts right

Trade policy doesnt affect S or I , so capital
flows and the supply of dollars remains fixed.
33
Trade policy to restrict imports
Results ?e gt 0 (demand increase) ?NX
0(supply fixed) ?IM lt 0 (policy) ?EX lt 0(rise
in e )
34
Import Restrictions - Summary

• NX does not change, because real exchange rate
  appreciates
• While NX unchanged, both exports and imports
  fall, so overall trade decreases hurts world
  economy

35
Nominal exchange rate

• e ?? x (P/P) (e foreign currency price of
  )
• Increase in foreign price, P, level causes rate
  to appreciate
• Increase in domestic price, P, level causes
  nominal rate to depreciate

36
Nominal Exchange Rate

• ?e ?? ?P - ?P
• or
• ?e ?? (? - ?)
• Increase in e is appreciation
• High inflation countries have depreciating
  currency

37
Inflation and nominal exchange rates 1972-2004
Percentage
10
change
9
in nominal
8
exchange
South Africa
rate
7
6
Depreciation
relative to
Italy
5
U.S. dollar
4
New Zealand
Australia
Spain
3
Sweden
Ireland
2
Canada
1
UK
France
Belgium
0
-
1
Appreciation
Germany
Netherlands
relative to
-
2
U.S. dollar
Switzerland
-
3
Japan
-
4
-
1
-
2
-
3
1
0
2
3
4
5
6
8
7
Inflation differential
38
Purchasing Power Parity

• Goods should sell at same price in all countries
• Exchange rate adjustment equalizes cost of basket
  of goods across countries
• Law of One Price For traded goods
• e x P P
• e P/P
• ? 1

39
Purchasing Power Parity (PPP)

• If e P/P, then

and the NX curve is horizontal
Under PPP, changes in (S - I ) have no impact on
e or e.
40
Purchasing Power Parity

• Strict PPP does not hold
• Nontraded goods transport costs
• Goods not perfect substitutes
• In the long run, nominal rates adjust toward PPP
  values

41
Economists Big Mac PPP
42
Large Open Economy

• Between extremes of closed and small, open
  economies
• Consider fiscal expansion case

43
A fiscal expansion in three models
A fiscal expansion causes national saving to
fall.The effects of this depend on the degree of
openness
rises, but not as much as in closed economy
rises
nochange
nochange
falls, but not as much as in closed economy
falls
falls
no change
falls, but not as much as in small open economy
44
CASE STUDY The Reagan deficits revisited
Data decade averages all except r and e are
expressed as a percent of GDP e is a
trade-weighted index.