Chapter 8 The Open Economy at Full Employment

1
Chapter 8The Open Economy at Full Employment
2
The Open Economy

• Open economy trades goods and services and
  capital with the rest of the world (ROW)
• Investment and the government deficit can be
  financed by domestic savings by households or by
  foreigners.
• (Sp Sg) NCF I, where NCF net capital
  flows
• When NCF gt 0, capital flows into the U.S. economy
  from ROW.
• When NCF lt 0, capital flows out of the U.S.
  economy to ROW.

3
Switzerland (a)

• Switzerland is a small open economy.
• The Swiss must take the real-world interest rate
  as their own (ignore risk).
• If rSwiss lt r where r is the world real
  interest rate, then Switzerland would have no
  capital.
• All the capital would leave the country for the
  higher returns abroad (this assumes there are no
  restrictions on the export of capital, called
  capital controls).
• There is no reason to offer rSwiss gt r since the
  country can get all the capital it needs from the
  ROW by offering r.

4
Switzerland (b)

• Switzerland faces an infinitely elastic
  (horizontal) supply of capital at r.
• Investment spending is still a negative function
  of the real interest rate.
• For Switzerland r r so the real interest rate
  cannot adjust to changes domestically, therefore
  NCF must adjust to maintain equilibrium of
  leakages injections.

5
Switzerland What happens if the G increases? (c)

• Suppose G ? in a small open economy at full
  employment.
• As before, national savings S ? because
  government savings Sg ?.
• The saving curve shifts left.
• Since r r, a gap opens between national
  savings and investment.
• This gap is NCF foreign capital flows into the
  economy to make up the difference between
  national savings and total investment.
• In a small open economy there is no crowding out
  of investment!
• Downside Increased foreign borrowing must be
  repaid in the future
• These payments to foreigners may lower future
  living standards.

Supply of savings in a small open economy. B0
original international borrowing B1 new
international borrowing
6
The United States Economy (a)

• The United States is a large open economy.
• Changes in the United States have effects on the
  world real interest rate r.
• U.S. savings account for 20 of world savings.
• A decrease in U.S. savings would raise world
  interest rates.
• This chokes off some U.S. investment as in the
  closed economy case, but the magnitude of
  crowding out would be lower due to foreign
  capital inflows.

7
The United States Economy (b)

• In the decades after World War II, if U.S.
  savings fell by 1 billion, U.S. investment fell
  by about 1 billion as in a closed economy.
• Today if U.S. savings fell by 1 billion,
  investment would only fall by between 350 and
  500 million.
• This implies that today foreigners are more able
  and willing to invest in the United States.

8
Determination of the Trade Balance

• Sp Sg NCF I
• Remember, Sp Yf - T - C, and Sg T G
• Using these expressions we can write
• (Yf T C) (T G) NCF I
• From equilibrium of expenditure and output we
  have
• Yf C I G NX in full-employment
  equilibrium
• Using this for Yf above and simplifying we get
• NX NCF 0

9
Net Exports plus Net Capital Flows

• Net exports net capital flows 0.
• If NX lt 0, then NCF gt 0.
• A trade deficit (NX lt 0) must be financed by
  capital inflows (NCF gt 0).
• Rewrite this as NCF Exports - Imports 0.
• NCF Exports Imports. A country's imports are
  paid for out of revenues earned from exports plus
  any capital inflows.

10
The U.S. Fiscal Deficit and Trade Deficit

• The trade deficit and government budget deficit
  often move together but not always
• In the 1980s increases in the budget deficit were
  accompanied by increases in foreign borrowing and
  a trade deficit. During the late 1990s the fiscal
  deficit fell but the trade deficit increased.

11
National Saving, Investment and Net Capital Flows

• In the 1980s national saving fell while
  investment rose so the United States had a large
  capital inflow. In the early 1990s national
  saving rose and capital inflows fell. By 2000
  national saving had declined and net capital
  inflows increased.

12
What happened?

• The 1980s saw a downward trend in Sp.
• Investment rose until 1984, then fell.
• NCF rose until late in the 1980s, so borrowing
  from foreigners increased to pay for the
  government deficit.
• In the 1990s, the government deficit fell after
  1991, so ?Sg gt 0.
• This allowed other variables to increase.
• Sp rose after 1991.
• Investment rose after 1991.
• NCF rose after 1991.

13
U.S. Imports and Exports

• Insert figure (unlabelled) from chapter 8 of the
  macro split of the 4th edition of Stiglitz and
  Walsh in E-Insight Box on High-Tech Exports and
  Imports

14
Exchange Rates

• Exchange rates how much of one country's
  currency trades for a given amount of another
  country's currency
• The bilateral exchange rate e is the exchange
  rate between two countries' currencies.
• e Japanese yen/U.S. dollar 105 yen/1
• If e increases to 120 yen/1, then the dollar
  buys more yen. The dollar appreciates against the
  yen or the yen depreciates against the dollar

15
The Trade-Weighted Value of the U.S. Dollar

• The trade-weighted exchange rate is the weighted
  average of the exchange rates between the dollar
  and the currencies of our major trading partners.

16
Trade-Weighted Exchange Rate (b)

• The U.S. trade-weighted exchange rate peaked in
  1985the Golden Dollar.
• In the early 1990s it fluctuated around a steady
  value.
• From the mid-1990s the dollar increased in value
  against the currencies of our major trading
  partners.
• Since 2002 the dollar has lost value.

17
The Supply of U.S. Dollars

• U.S. citizens supply of dollars to buy foreign
  goods and investments
• The supply curve is upward sloping.
• If e ?, foreign currency and foreign goods are
  cheaper, so U.S. residents supply a greater
  quantity of dollars.
• The supply curve of dollars shifts when U.S.
  residents wish to
• Buy more imported goods
• Invest more in foreign countries
• Take more trips abroad

18
The Demand for U.S. Dollars

• The demand curve for dollars represents the
  demand by foreigners for U.S. currency.
• The demand curve is downward sloping.
• If e ?, the dollar is more expensive to
  foreigners so they buy fewer dollars.
• The demand curve for dollars shifts right when
  foreigners want to
• Buy more U.S. exports
• Invest more in the United States
• Take more trips to the United States

19
Equilibrium
20
The Effects of Increased Foreign Borrowing

• Suppose the United States borrows more from
  foreigners, say, from Japan.
• To attract Japanese investors, the U.S. interest
  rate must rise.
• The increased demand for dollars by Japanese
  investors shifts the demand curve for dollars to
  the right since high U.S. interest rates make
  U.S. investments attractive to Japanese
  investors.
• The supply of dollars shifts to the left because
  Japanese investments are less attractive to U.S.
  investors.
• In equilibrium there is a higher exchange rate
  the dollar appreciates against the yen.
• Fluctuations in the exchange rate ensure that the
  trade balance and foreign borrowing move
  together that is, NX NCF 0.

21
The Effects of Increased Foreign Borrowing
(continued)
22
Is the Trade Deficit a Problem?

• A trade deficit implies an increase in foreign
  borrowing.
• Like any borrowing this may be good or bad, but
  it certainly must be repaid.
• The benefits of a trade deficit and the
  associated borrowing depend on how the borrowed
  funds are used.
• If the borrowing finances investment, which
  increases the capital stock and boosts future
  income, then this will help the country pay
  foreigners in the future without reducing
  consumption.
• On the other hand, if the trade deficit finances
  current consumption, by either consumers or the
  government, then future generations are worse off
  because they get no benefits from the current
  trade deficit but bear the costs of repayment.