Principles of Macroeconomics
lectures
Week 15
A Macroeconomic Theory of the
Open Economy
CH32
2
IN THIS LECTURE
• In an open economy, what determines the
real interest rate? The real exchange rate?
• How are the markets for loanable funds and
foreign-currency exchange connected?
• How do government budget deficits affect the
exchange rate and trade balance?
• How do other policies or events affect the
interest rate, exchange rate, and trade
balance?
Theory of the Open Economy – 1
• Assumptions:
– Economy’s GDP is given
• Real GDP is determined by factors of
production and available technology
– Economy’s price level is given
• Price level adjusts to bring the supply and
demand for money into balance
3
Theory of the Open Economy – 2
• The model
– Highlights the forces that determine the economy’s
trade balance and exchange rate
– Looking simultaneously at two related markets:
• The market for loanable funds
• The market for foreign-currency
exchange
4
The Market for Loanable Funds – 1
• In an open economy, S = I + NCO
Saving = Domestic investment + Net capital outflow
• Market for loanable funds:
– Supply of loanable funds: from national saving (S)
– Demand for loanable funds: from domestic
investment (I) and net capital outflow (NCO)
5
The Market for Loanable Funds – 2
• Net outflow of capita when NCO > 0
– Net purchase of capital overseas adds to the
demand for domestically generated loanable funds
• Net inflow of capital when NCO < 0
– Capital resources coming from abroad reduce the
demand for domestically generated loanable funds
6
7
How NCO depends on the real interest rate
The real interest rate, r, is
the real return on domestic
assets.
A fall in r makes domestic
assets less attractive
relative to foreign assets.
– People at home country
purchase more foreign
assets.
– People abroad purchase
fewer domestic assets.
– NCO rises.
Net capital outflow
r
r1
r2
NCO
NCO1 NCO2
NCO
8
The market for loanable funds diagram
Loanable funds
r
S = saving
• Both I and NCO
depend negatively on r,
so the D curve is
downward-sloping.
• r adjusts to balance
supply and demand in
the LF market.
r1
D = I + NCO
LF
EXAMPLE 1: Budget deficits and
capital flows
Suppose the government runs a budget deficit
(previously, the budget was balanced).
• Use the appropriate diagrams to determine
the effects on the real interest rate and net
capital outflow.
9
1
0
EXAMPLE 1: Solution
When working with this model, keep in mind:
The
A budget
higherdeficit
r makes
reduces
domestic
saving
bonds
and the
more
supply
attractive
of LF,
the LF market determines r (in left graph),
relative
causingtor then
to
foreign
rise.
bonds,
this value
of r reduces
determinesNCO.
NCO (in right graph).
Loanable funds
Net capital outflow
r
r
S2
S1
r2
r2
r1
r1
D1
NCO1
LF
NCO
Foreign-Currency Exchange Market – 1
• The market for foreign-currency exchange
– Trade domestic currency in exchange for foreign currencies
– Identity: NCO = NX
– NX is the demand for domestic currency: foreigners need
it to buy net exports.
– NCO is the supply of domestic currency: residents sell
domestic currency to obtain the foreign currency
they need to buy foreign assets.
11
Foreign-Currency Exchange Market – 2
• The real exchange rate (E)
– Measures the quantity of foreign goods & services
that trade for one unit of domestic goods &
services.
– E is the real value of a domestic currency in the
market for foreign-currency exchange.
– E balances the supply and demand in the market
for foreign-currency exchange
12
13
The market for foreign-currency exchange
• An increase in E makes
domestic goods more
E
expensive to foreigners,
and reduces the quantity
of domestic currency
demanded to buy those
E1
goods.
• An increase in E has no
effect on S or I, so it does
not affect NCO or the
supply of currency.
Supply =
NCO
Demand = NX
Domestic currency
• E adjusts to balance supply and demand for domestic
currency in the market for foreign- currency exchange.
Budget deficits, again
Initially, the government budget is balanced
and trade is balanced (NX = 0).
Suppose the government runs a budget deficit.
As we saw earlier, r rises and NCO falls.
• How does the budget deficit affect the real
exchange rate? The balance of trade?
16
17
Active Learning 1: Answers
The budget deficit
reduces NCO and the
supply of currency.
• The real exchange
rate appreciates,
reducing net
exports.
Since NX = 0 initially,
the budget deficit
causes a trade deficit
(NX < 0).
Market for foreigncurrency exchange
E
S2 = NCO2
S1 = NCO1
E2
E1
D = NX
Currency
The Effects of a Budget Deficit –
1
• The effects of a budget deficit:
– National saving falls
– The real interest rate rises
– Domestic investment and net capital outflow both
fall
– The real exchange rate appreciates (E increases)
– Net exports fall (or, the trade deficit increases)
19
The connection between r and E
Anything that increases r
r
will reduce NCO
r2
NCO
and the supply of currency in the
r1
foreign exchange market.
Result: The real exchange rate
appreciates.
Keep in mind: The LF market
(not shown) determines r.
This r determines NCO (shown E
in upper graph).
This NCO determines supply
E2
of currency in foreign exchange
E1
market (in lower graph).
NCO2
S2
NCO2
NCO1
NCO
S1 = NCO1
D = NX
NCO1
Currency
Investment incentives
Suppose the government provides new tax
incentives to encourage investment.
• Use the appropriate diagrams to determine
how this policy would affect:
A. the real interest rate, r
B. net capital outflow, NCO
C. the real exchange rate, E
D. net exports, NX
22
2
3
Answers, A and B
Investment—and the demand for LF—increase at each
value of r.
r rises, causing NCO to fall.
r
Loanable funds
r
Net capital outflow
S1
r2
r2
r1
r1
D1
D2
NCO
LF
NCO
NCO2
NCO1
24
Answers, C and D
Market for foreignThe fall in NCO
currency exchange
reduces the
S2 = NCO2
supply of domestic
currrency
E
S1 = NCO1
in the foreign
exchange market. E2
The real exchange
rate appreciates,
reducing net
exports.
E1
D = NX
Dollars
Effects of Investment Incentives
• A tax incentive for investment has similar effects
as a budget deficit:
– r rises, NCO falls
– E rises, NX falls
• But one important difference:
– Investment tax incentive increases investment, which
increases productivity growth and living standards in
the long run.
– Budget deficit reduces investment, which reduces
productivity growth and living standards.
25
Trade Policy
• Trade policy:
– Government policy that directly influences the
quantity of goods and services a country imports or
exports
– Tariff: a tax on imported goods
– Import quota: limit on the quantity of imports
• Some arguments for restricting trade:
– Save jobs in domestic industry
– Reduce the trade deficit
27
Protecting domestic auto makers
Suppose the government uses import quotas on cars
imported from Japan, in order to protect jobs in the
domestic auto industry.
• Use the appropriate diagrams to determine how
this policy would affect:
A. the real interest rate, r
B. net capital outflow, NCO
C. the real exchange rate, E
D. net exports, NX
E. Does the policy saves jobs?
28
29
EXAMPLE 3: Solution, A and B
An import quota does not affect saving or investment,
so it does not affect NCO. (Recall: NCO = S – I.)
r
Loanable funds
r
Net capital outflow
S
r1
r1
D
NCO
LF
NCO
30
EXAMPLE 3: Solution, C
Since NCO is unchanged,
S curve does not shift.
The D curve shifts:
At each E, imports of cars E
fall, so net exports rise,
D shifts to the right.
E2
At E1, there is excess
demand in the foreign
exchange market.
E rises to restore
equilibrium.
Market for foreigncurrency exchange
S = NCO
E1
D2
D1
Dollars
EXAMPLE 3: Solution, D
• What happens to NX? Nothing!
– If E could remain at E1, NX would rise, and the
quantity of dollars demanded would rise.
– But the import quota does not affect NCO,
so the quantity of dollars supplied is fixed.
– Since NX must equal NCO, E must rise enough to
keep NX at its original level.
Hence, the policy of restricting imports does not
reduce the trade deficit.
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32
EXAMPLE 3: Solution, E
Does the policy save jobs? US case
The quota reduces imports of Japanese autos:
– U.S. consumers buy more U.S. autos.
– U.S. automakers hire more workers to produce these
extra cars.
– So the policy saves jobs in the U.S. auto industry.
• But E rises, reducing foreign demand for U.S.
exports.
– Export industries contract, exporting firms lay off
workers.
The import quota saves jobs in the auto industry but
destroys jobs in U.S. export industries!!
Political Instability and Capital
Flight
• 1994: Political instability in Mexico made world
financial markets nervous.
– People worried about the safety of Mexican assets
they owned
– People sold many of these assets, pulled their
capital out of Mexico
• Capital flight:
– Large and sudden reduction in the demand for
assets located in a country
33
34
Capital flight from Mexico – 1
As foreign investors sell their assets and pull out their
capital, NCO increases at each value of r.
Demand for LF = I + NCO. The increase in NCO increases demand
for LF. The equilibrium values of r and NCO both increase.
r
Loanable funds
r
Net capital outflow
S1
r2
r2
r1
r1
D2
D1
NCO2
NCO1
LF
NCO
35
Capital flight from Mexico – 2
The increase in NCO
causes an increase in
the supply of pesos in
the foreign exchange
market.
The real exchange
rate value of the peso
falls.
Market for foreigncurrency exchange
E
S1 = NCO1
S2 = NCO2
E1
E2
D1
Pesos
4/1/1995
3/12/1995
2/20/1995
1/31/1995
1/11/1995
12/22/1994
12/2/1994
11/12/1994
10/23/1994
US Dollars per currency unit .
36
Examples of capital flight: Mexico, 1994
0.35
0.30
0.25
0.20
0.15
0.10
7/19/1998
100
4/25/1998
120
1/30/1998
11/6/1997
8/13/1997
5/20/1997
2/24/1997
12/1/1996
1/1/1997 = 100
US Dollars per currency unit.
37
Examples of capital flight: S.E. Asia, 1997
South Korea Won
Thai Baht
Indonesia Rupiah
80
60
40
20
0
12/31/1998
11/21/1998
10/12/1998
9/2/1998
7/24/1998
6/14/1998
5/5/1998
US Dollars per currency unit .
38
Examples of capital flight: Russia, 1998
0.20
0.16
0.12
0.08
0.04
0.00
1/12/2003
10/24/2002
8/5/2002
5/17/2002
2/26/2002
12/8/2001
9/19/2001
7/1/2001
U.S. Dollars per currency unit .
39
Examples of capital flight: Argentina, 2002
1.2
1.0
0.8
0.6
0.4
0.2
0.0
Capital Flows from China
• China accumulated foreign assets:
– From 2000 to 2014, increased from $160 billion to $4
trillion
– But from 2016 to 2018: China's reserves of foreign
assets fell by almost $1 trillion
• Results in U.S.:
– Appreciation of $ relative to Chinese renminbi
– Higher U.S. imports from China
– Larger U.S. trade deficit
– The inflow of capital reduced U.S. interest rates,
increasing investment in the U.S. economy
41
Principles of Macroeconomics
lectures
Week 15
Aggregate Demand and
Aggregate Supply
Ch33
GDP across the EU measured in current US dollars on the
vertical axis over the period 1961 – 2017.
FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH
EDITION 9781473725331 © CENGAGE EMEA 2017
Growth rates of real GDP
Growth rates of GDP, nominal
https://www.imf.org/external/datamapper/
NGDP_RPCH@WEO/OEMDC/ADVEC/W
EOWORLD
Growth rates of GDP Kazakhstan nominal
https://www.imf.org/external/datamapper/
NGDP_RPCH@WEO/OEMDC/ADVEC/W
EOWORLD
Growth rates of real GDP, consump., investment
• Percent
change
from 4
quarter
s earlier
Okun’s law
The Assumptions of Classical
Economics
• The Classical Dichotomy
– Separation of variables into two groups:
• Real – quantities, relative prices
• Nominal – measured in terms of money
• The neutrality of money:
– Changes in the money supply affect
nominal but not real variables
49
The Reality of Short-Run
Fluctuations
• Classical theory
– Describes the world in the long run, but not
the short run
• In the short run
– Changes in nominal variables (like the
money supply or P ) can affect real
variables (like Y or the u-rate).
– We use a new model…
50
Model of aggregate demand and aggregate
supply
The price level
P
“Short-Run Aggregate
Supply”
The model determines the
equilibrium price level
SRAS
P1
AD
“Aggregate Demand”
and equilibrium output (real
GDP).
Y1
Real GDP, the
quantity of output
Y
The aggregate-demand (AD) curve
The AD curve shows the
quantity of all g&s
P
demanded in the economy P
2
at any given price level.
Why the AD curve slopes
downward?
P
1
Y = C + I + G + NX
Assume G is fixed by
government policy.
AD
Y2
Y1
Y
To understand the slope of AD, must determine how a
change in P affects C, I, and NX.
52
The Wealth Effect (P and C )
• Suppose the price level, P, declines
– Increase in the real value of money
– Consumers are wealthier
– Increase in consumer spending, C
– Increase in quantity demanded of goods
and services
53
The Interest-Rate Effect (P and I)
• Suppose the price level, P, declines
– Buying goods and services requires less
money: people buy bonds and other assets
– Decrease in the interest rate
– Increase spending on investment goods, I
– Increase in quantity demanded of goods
and services
54
The Exchange-Rate Effect (P and
NX )
• Suppose the domestic price level, P,
declines
– Decrease in the domestic interest rate
– Domestic currency depreciates (decline in
the real value of the currency in foreignexchange markets)
– Stimulates net exports, NX
– Increase in quantity demanded of goods
and services
55
Why the AD curve slopes downward
An increase in P
reduces the quantity
of goods and
services demanded
because:
• the wealth effect
(C falls)
• the interest-rate
effect (I falls)
• the exchangerate effect (NX
falls)
P
P2
P1
AD
Y2
Y1
Y
56
EXAMPLE 1: A shift in the AD curve
What is the effect of a
stock market boom on the
AD curve?
P
A stock market boom
makes households feel
wealthier, C rises,
P1
the AD curve shifts right.
Any event that changes
C, I, G, or NX (except
a change in P) will shift
the AD curve.
AD2
AD1
Y1
Y2
Y
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58
Why the AD Curve Might Shift – 1
• Changes in C
– Stock market boom/crash (housing market?)
– Preferences re: consumption/saving tradeoff
– Tax hikes/cuts
• Changes in I
–
–
–
–
–
Firms buy new computers, equipment, factories
Expectations, optimism/pessimism
Interest rates,
Monetary policy,
Investment tax incentives
59
Why the AD Curve Might Shift – 2
• Changes in G
– e.g., defense
– e.g., roads, schools
• Changes in NX
– Booms/recessions in countries that buy our exports
– Appreciation/depreciation resulting from
international speculation in foreign exchange
market
The aggregate-supply (AS ) curves
The AS curve
shows the total
quantity of
goods and services
firms produce and
sell at any given
price level.
P
LRAS
SRAS
AS is:
▪ upward-sloping in
short run
▪
Y
vertical in long
run
62
The long-run aggregate-supply curve (LRAS)
The natural rate of
output (YN) is the amount
of output the economy
produces when
unemployment is at its
natural rate.
P
LRAS
Also called
potential output
or
full-employment output.
YN
Y
63
Why LRAS is vertical
YN determined by the
economy’s stocks of
labor, capital, and
natural resources,
and on the level of
technology.
P
LRAS
P2
An increase in P
does not affect any of
these, so it does
not affect YN.
(Classical dichotomy)
P1
YN
Y
64
66
Why the LRAS Curve Might Shift – 1
• Changes in L or natural rate of unemployment
– Immigration
– Baby-boomer retire, pension reform
– Government policies reduce natural u-rate
• Changes in K or H
– Investment in factories, equipment
– More people get university degrees
– Factories destroyed by a hurricane
67
Why the LRAS Curve Might Shift – 2
• Changes in natural resources
– Discovery of new mineral deposits
– Reduction in supply of imported oil
– Changing weather patterns that affect
agricultural production
• Changes in technology
– Productivity improvements from technological
progress
Using AD & AS to depict long-run
growth & inflation
Over the long run,
LRAS2020
tech. progress
LRAS2010
P
shifts LRAS to the
LRAS2000
right
• and growth in
P2020
the money
supply shifts AD
P2010
to the right.
AD2020
P
• Result:
2000
ongoing
AD2010
inflation and
AD2000
growth in
Y
Y2000 Y2010 Y2020
output.
68
Short run aggregate supply
(SRAS) curve
The SRAS curve
is upward sloping:
Over the period
of 1–2 years,
an increase in P
P
SRAS
P2
P1
• causes an
increase in the
quantity of goods
and services
supplied.
Y1
Y2
Y
69
Why the Slope of SRAS Matters
If AS is vertical,
P
fluctuations in AD
Phi
do not cause
fluctuations in
Phi
output or
employment.
LRAS
SRAS
ADhi
Plo
If AS slopes up,
then shifts in AD
do affect output
and employment.
AD1
Plo
ADlo
Ylo
Y1
Yhi
Y
70
The Great Recession of 2008–2009
• Large contractionary shift in AD
– Real GDP fell sharply
• By 4.2% between the forth quarter of 2007 and the second
quarter of 2009
– Employment fell sharply
• Unemployment rate rose from 4.4% in May 2007 to 10.0%
in October 2009
• The housing market played a central role in
this recession.
71
The Great Recession of 2008–2009
• Rising house prices during 2002–2006 due to:
– Low interest rates
– Easier credit for subprime borrowers
– Government policies to increase homeownership
– Securitization of mortgages: investment banks
purchased mortgages from lenders,
• Created securities backed by these mortgages,
• Sold the securities to banks, insurance companies, and
other investors.
– Mortgage-backed securities perceived as safe,
since house prices “never fall”
72
The Great Recession of 2008–2009
• Consequences of 2006–2009 housing market crash:
– Millions of homeowners “underwater”—owed more
than house was worth.
– Millions of mortgage defaults and foreclosures.
– Banks selling foreclosed houses increased surplus
and downward price pressures.
– Housing crash badly damaged construction
industry: 2010 unemployment rate was 20.6% in
construction vs. 9.6% overall.
73
The Great Recession of 2008–2009
• Consequences of 2006–2009 housing market
crash:
– Mortgage-backed securities became “toxic,”
• Heavy losses for institutions that purchased them,
• Widespread failures of banks and other financial
institutions.
– Sharply rising unemployment and falling
GDP.
74
The Great Recession of 2008–2009
• The policy response:
– Federal Reserve reduced Fed Funds rate target to
near zero.
– Federal Reserve purchased mortgage-backed
securities and other private loans.
– U.S. Treasury injected capital into the banking
system to increase banks’ liquidity and solvency in
hopes of staving off a “credit crunch.”
– Fiscal policymakers increased government
spending and reduced taxes by $800 billion.
75