Open-economy macroeconomics
Finish savings experiment
Thoughts on sources of technological change
Real business cycles: A sketch
Open economy macroeconomics
• International financial system
• Short-run open-economy output determination (Mundell Fleming model)
• The rise, crisis, and (fall?) of the Euro
1
Bottom line this week
• Exports and imports affect aggregate demand,
particularly for very open economies.
• Openness is growing in trade and finance.
• Exchange rates are the monetary link among countries.
• In the open economy, the tail wags the dog
(tail = financial flows; dog = trade balance).
• US has a chronic trade surplus because people love to
put their money here (central banks and investors).
• Countries face a trilemma among fixed exchange rates,
domestic monetary policy, and open financial markets.
• Europe has made a fateful choice in the trilemma that is
devastating the continent with no end in sight.
2
New elements in open-economy macro
1.
2.
Trade flows:
- Exports and imports depend on relative prices (domestic to
foreign)
- These depend critically on exchange rate:
NX(R) = EX(R) – IM(R); NX’(R) < 0.
Financial capital increasingly “mobile”
– Free flow of finance among countries
– Investors compare domestic and foreign interest rates (rd, rw )
– Capital outflow (CF) = lending abroad = CF(rd, rw).
– In small economy, rd = rw = world interest rate (riskless)
3
Measuring international flows
4
Essential balancing property
of Balance of Payments
Current Account (≈NX)
Financial Balance (≈-CF)
Net Balance
A
-A
0
For macro purposes:
Net exports = capital outflow
NX = CF
5
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
6
Balance of Payments, 2011
Goods and services
Exports
Imports
Net income of foreign investments
Unilateral transfers, net
-560
2,103
-2,663
227
-133
Balance on Current Account
Net change in assets
Central banks
Other
Statistical discrepancy
-466
555
212
343
Balance on Financial Account
Net exports
-89
466
-569
* I have omitted "capital account," which is trivial in $ terms.
7
Globalization in trade of goods and services, US
.20
.18
Imports/GDP
Exports/GDP
.16
.14
.12
.10
.08
.06
Rising trend
.04
.02
1950
1960
1970
1980
1990
2000
2010
8
Open Economy Macro:
The transmission mechanism
through the real exchange rate
9
Exchange rates
Foreign-exchange rates are the relative prices of different
national monies or currencies.
Convention in Econ 122 and Jones: Nominal exchange rate
• Exchange rates = amount of foreign currency per unit of
domestic currency.
• Think Japanese Yen: 100 yen to $.
10
Terminology
For market-determined exchange rates:
• An appreciation of a currency is when the value of the
currency rises
– e or R rises
• A depreciation of a currency is when the value of the
currency falls
– e or R falls
For fixed exchange rates:
• Price set by government is the “parity.”
• A revaluation is an increase in the official parity.
• A devaluation is a decrease in the parity.
11
Index of US nominal exchange rate (e)
Appreciation
140
120
100
80
60
40
20
1970
1975
1980
1985
1990
1995
2000
2005
2010
Depreciation
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Real exchange rates
Real exchange rate, R [Jones uses RER)
R = nominal exchange rate corrected for relative prices
R = e × (p d / p f )
= p d / (p f / e)
= domestic prices/foreign prices in a common currency
Note: If you calculate the rate of growth of R, you get
 rate of real   rate of nominal   domestic
  foreign




 

appreciation
appreciation
inflation
rate
inflation
rate

 
 
 

Example of car exchange rate: 100 Yen/$; Toyota = 2,000,000Y;
Ford = $20,000; R = 100 * 20000/2000000 = 1 Toyota/Ford
13
Big Mac Real Exchange Rate
R = p d / (p f / e)
Example of Big Mac
Price in Beijing: 15.4Yuan
Price in New York: $4.20
Real exchange rate: $4.20/(Y15.4/6.32) = $4.07/( $3.67) = 1.72
People use this to argue that Yuan is 72% “undervalued.”
Anything wrong with this argument?
14
Real exchange rate of $ relative to major currencies (R)
Appreciation
Depreciation
15
Flight to safety in $
Internet bubble
Appreciation
Dollar bubble:
high $ interest rates
Real exchange rate of $ relative to major currencies (R)
Depreciation
16
Tree of Macroeconomics
yes
IS-MP,
dynamic AS-AD
longrun
Closed
economy
Short run or
long run?
(full adjustment
of capital,
expectations,
etc.)
shortrun
Classical
or non-classical?
(sticky wages
and prices, rational
expectations, etc.)
no
Keynesian model
(sticky wages
and prices,
upward-sloping
AS
Open
economy
Mundell-Fleming
model
17
The Mundell-Fleming Model for Open Economy
Mundell-Fleming (MF) model is short run Keynesian model for
open economy.
Very similar to IS-MP model.
It derives impact of policies and shocks in the short run for an
open economy.
Usual stuff for domestic sectors:
- Price and wage stickiness, unemployment, no inflation
- Standard determinants for domestic industries (C, I, G, financial
markets, etc.)
Open economy aspects:
- Small open economy would have rd = rw
- Large open economy financial flows (CF) determined by rd and
rw
- Net exports a function of real exchange rate, NX = NX(R)
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Goods market
Start with usual expenditure-output equilibrium condition.
New wrinkle is the NX function:
(1)
Y = C(Y - T) + I(rd) + G + NX(R)
Financial markets
Then the monetary policy equation.
(2)
r = L (Y)
Balance of Payments
Capital flows are determined by domestic and foreign interest rates. But
have BP balance:
(3)
CF(rd, rw) = NX(R)
Substituting (3) into (1), we get equation in Y and rd which is IS$ curve.
(IS$ )
Y = C(Y - T) + I(rd) + G + CF(rd, rw)
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Dollars out = debit
- I buy VW
- Yale buys Greek debt.
CF > 0 (outflow)
Dollars in = credit
- Marco comes to Yale.
- Worry warts buy T bills.
CF < 0 (capital inflow
20
A picture album
of the world economy,
2012
21
The output decline in the Great Recession
Percent change from prior year
All from the IMF, World Economic Outlook, Sept 2012.
22
Unemployment
during the Great
Recession
Percent of labor force
23
24
25
26
The growth in the
public debt around
the world
Debt/GDP ratio (%)
27
rd
Open Economy
MP$
CF=NX=0
Equilibrium
C+I(rd)+G+CF(rd) (IS$)
C+I(rd)+G (IS)
Y
28
Special Case I. Stimulus plan
How does openness change the impact of a stimulus plan?
Multiplier is reduced because some of the stimulus spills
into imports and stimulates other countries
Note that financial crisis and high risk premium is the
opposite (IS$ shift to the left)
29
rd
Fiscal Expansion
MP$
IS’
(S$’
IS
Open economy
IS$
Y
Closed economy
30
Special Case II. Normal Monetary Expansion
How does openness change the impact of a
monetary policy?
Double barreled effect of monetary policy
- Lower r → higher I (domestic investment)
- Lower r → higher CF → depreciates exchange rate (R)
→ raises NX (foreign investment)
31
rd
Monetary Expansion
MP$
MP$’
IS$
IS
Open economy
Y
Closed economy
32
Special Case III
What about a liquidity trap?
Note that monetary policy cannot work on either of the
two mechanisms in a liquidity trap.
- Interest rates stuck and cannot stimulate domestic investment.
- With no change in interest rates, no change in CF (financial
flows), no change exchange rate, no change NX
So open economy does not change the basic liquidity trap
dilemma!
33
Monetary Expansion in Liquidity Trap
rd
IS$
MP$’
MP$
Equilibrium
Y
34
You do fiscal expansion
rd
IS$
MP$
Equilibrium
Y
35
The International Monetary System
36
What is the international monetary system?
International monetary system denotes the institutions under
which payments are made for transactions that cross national
boundaries and are made in different currencies.
In particular, the international monetary system determines how
foreign exchange rates are set and how governments can
affect exchange rates.
37
Exchange rate regimes
I. . Fixed exchange rate
A. Currency union: currencies irrevocably fixed
- US states (1789 - )
- Eurozone (2001- ?)
B. Other fixed exchange rate regimes:
– Gold standard (1717 - 1933)
– Bretton Woods (1945 - 1971)
II. Flexible exchange rates
- Currencies are market determined
- Governments use monetary policies to affect exchange rates
38
What are desirable characteristics
of an international financial system?
1. Stability of exchange rates to lower risk and promote trade
and capital flows.
2. Openness of financial markets to promote efficient allocation
and diffusion of best-practice technologies
3. Adjustment to macroeconomic shocks through monetary
policy
But we will see that these three goals are not compatible in the
“fundamental trilemma”
39
The share of floating has increased sharply
(% of world GDP)
Share of world GDP by floaters
100%
80%
60%
40%
20%
0%
1960
1970
1980
1990
2000
40
The Fundamental Trilemma
Country can choose only two the three objectives: fixed exchange rate,
open financial markets, or monetary independence:
1. Country can have fixed exchange rate and retain monetary
policy. But this would require maintaining controls on financial
flows.
- China today and early Bretton Woods;
2. Country can leave financial movements free and retain monetary
autonomy, but only by letting the exchange rate fluctuate.
- Euro countries and US
3. Country can have open financial markets and stabilize the
currency, but only by abandoning monetary policy as
countercyclical tool.
- Argentina yesteryear, individual countries of Euroland, Hong Kong
41
History of Eurozone
-
Gold standard through 1914, suspended WW I, reinstates 1920s.
Long war (1914 – 1945) followed by political union after 1945.
Gold standard deepened the Great Depression
Reconstruction with Bretton Woods system (1945- 1971)
Common Market and European Community (1958 – 1993)
European Monetary System (1978 - 1988): fixed rates of major
countries
Delors plan for monetary union (1989)
Irrevocable fixing of rates for Eurozone (2001)
Full establishment (1999) and adopted by 17 countries as of 2012
Growing imbalances after 2001
World financial crisis 2008 weakened public finances
Eurozone crisis begins in Ireland, spreads to Greece, then to Italy
According to Euroskeptics, the end of the Eurozone is nigh…
42
Eurozone 2012
43
Major “flow” problem: no way to adjust to imbalances
which lead to changes in real exchange rate (R)
1.5
1.4
1.3
Greece
Spain
Italy
France
Germany
Austria
1.2
1.1
1
0.9
0.8
0.7
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
44
Greece, Spain, Italy: The Sweet Life Turns Sour
rEuro + risk
premium
rEuro
IS$(2010)
Y2012
Y2010
IS$(2000)
Y2000
45
Options according to Nouriel Roubini*
1. Rapid Growth of Eurozone
–
–
ECB lowers rates, Euro depreciates, Germany expands
Problem: No way Germany will allow
2. Long Recession to Restore Periphery Competitiveness.
- Austerity in periphery
- Problem: No way citizens of Greece, Italy, etc. will put up with
3. The Core Permanently Subsidizes the Periphery
(“transfer union”)
- Problem: No way Germany will subsidize Greece and Italy
4. Widespread Debt Restructurings and EZ breakup
- Default?
- Problem: will lead to world financial meltdown.
* Former Yale Department of Economics Professor.
46