Chapter 6. The Open Economy.
Glancing at the Appendix
Old Chapter 5.
Homework: P. 164-65 #1, 2, 3, 7
macromodel open_economy #1, 3, 8
Chapter 6. Open Economy
H.W. p. 165, #1, 2, 3, 7
open_economy #1, 3, 8
Link to syllabus
Appendix shows how US is a mix of
closed economy and SOE.
Figure 5.1 p. 118. Exports and Imports as % of GDP.
Figure 6.1 p. 134. Exports and Imports
as % of GDP.
Point is that U.S. trades less, and that
U.S. and U.K. have negative trade
balances.
Talk about foreign trade, and the determination of exchange rate.
Assumptions for SOE model in chapter 6:
Perfect capital mobility, cannot affect world prices or interest rates.
World interest rate is r*. Implicitly, the rest of the world is a large
country. Notation: the (*) refers to foreign countries.
Output is fixed at Ybar, because K and L are fixed.
And, as before,
Consumption is function of disposable income C = C(Y – T)
If Y, G, and T are fixed, so are C and S
Investment depends on real interest rate I = I(r )
Major relation:
Using income/expenditure identity, Y = C + I + G + NX
Y-C-G - I = NX
S - I = NX (page 136)
(where as before S is National saving)
‘Other interpretations:
C + pers.sav + T = C + I + G + NX ; (Pers.sav – I) + (T-G) = NX
(inter-realtionship between three gaps)
also
NX = Y – (C + I + G) or NX = output – spending
(we have a trade deficit because we spend too much).
In a floating exchange rate, NX + net capital inflow =0 or
NX=capital outflow
2
Table 5.1 p. 118.
Table 6.1 p. 137. International flows of
goods and capital.
Various ways of indicating the three
situations.
Because we assume Y = Ybar, C=Cbar, S=Sbar, we can write
NX = [Ybar – C(Ybar – T) – G] - I(r*) or NX = Sbar –I(r*)
Figure 5-2 p. 122. Saving and Investment in a
Small Open Economy
Figure 6-2 p. 142. Saving and
Investment in a Small Open Economy
If r* is high, there will be a trade
surplus; if r* is low, trade deficit.
Figure 5-2 p. 128. Saving and Investment in a
Small Open Economy
Figure 6-2 p. 142. Saving and
Investment in a Small Open Economy
(repeated, with low r*)
r*
NX < 0
*
If r were down here, the country would have a trade deficit.
That’s a good description of the situation in the US today.
The US Balance of Payments, 2007. (other text)
The US
Balance of
Payments,
2007. K/W
The US Balance of Payments, 2007.
Other Text
Exports minus
Imports
Net Capital
Inflows
≈0
Point is that: current account + financial (capital) account ≈ 0
or, net exports = - financial account = - net capital inflows
= net capital outflows. NX = S – I . (Mankiw, p. 123)
Point is that: current account + financial (capital) account ≈ 0
or, net exports = - financial account = - net capital inflows
3
or net personal savings plus net gov’t savings plus net foreign
savings equals zero. Interpretation of savings being used to
finance domestic investment or overseas spending.
Three exercises: Increase G (same as decrease T), increase I,
foreign expansion (raising r*). Note that Mankiw won’t do effect
of M, because of classical model. Similarly x-rate treated later.
Figure 6-3. P. 143. Fiscal Expansion in a Small Open Economy
If G increases, NX falls; no change in real GDP, by assumption.
Figure 6-3. P. 143. Fiscal Expansion in a
Small Open Economy
If G increases, S (=Ybar-Cbar-G) moves
left, and at r*, (S-I<0), so there is a trade
deficit. (Different kind of crowding out).
Familiar result. (also Cbar,Tbar, I
increases. Same results if T falls.
Fig. 6-4 p. 144. Fiscal Expansion Overseas and a
Small Open Economy
Fig. 6-4 p. 144. Fiscal Expansion
Abroad and a Small Open Economy.
Will raise world interest rates, creating a
trade surplus at home. (Perhaps new
result)
How domestic economy is affected by foreign economic events.
Fig. 6-5 p. 145. Shift of the Investment Curve
in a Small Open Economy
Fig. 6-5 p. 145. Increase in the demand
for investment (investment tax credit) in
a Small Open Economy.
Creates a trade deficit
An increase in the demand for domestic investment lowers net exports.
Fig. 6-6 p. 147. The
Trade Balance and
Savings/Investment in
the U.S.
Fig. 6-6 p. 147. The Trade Balance and
Savings/Investment in the U.S.
(graph uses national saving).
4
Exchange rates. Notation: Nominal (e )-foreign cur. per $ (£/$)
If e increases (corresponding to an appreciation of the $), we buy
more imports, and export less,. Thus NX has a downward
slope if graphed against e.
Real exchange rate (ε) is the relative price of goods in two
countries.
ε = e x (P/P*) equals ratio of our prices in their currency, to their
prices in their currency.
If the real exchange rate is high, then foreign goods are relatively
cheap for us, and our goods are relatively expensive. This
leads to NX = NX(ε) with the negative slope.
Fig. 6-7 p. 152. Net Exports and the Real Exchange Rate
Why? Consider the real
exchange rate between
US and UK. In this case
ɛ= £/$ x PUS/PUK.
Suppose the exchange
rate £/$ increases from
0.8 £/$ to 1.4 £/$.
This would cause US
exports to fall.
Fig. 6-7 p. 152. Net Exports and the
Real Exchange Rate
NX = NX(ε) .
If the price of US exported wheat is $100/ton, then the price in
England of US wheat will rise from £80 to £140 [$100 x 0.8 £/$].
So England will buy less US wheat, and our net exports will fall.
An increase on the vertical axis causes a leftward movement along
the horizontal axis.
Different Text!!
The market for foreign currency in the U.S.
Depreciation
of US $
Appreciation
of US $
Fig. 5-7 p. 138. Net Exports and the Real Exchange Rate
Link to x-rates.com
The vertical axis in that book is the inverse of what it is in the Mankiw text.
Will analyze the determination of the real exchange rate by a graph
of S-I and NX. Can think of S-I as net supply of dollars, while
NX is the net demand for dollars by foreigners.
(Seems to be parallel to the market for dollars overseas).
5
Fig. 5-8 p. 131. Determination of the the Real Exchange Rate
Fig. 6-8 p. 152. Determination of the
Real Exchange Rate
Repeated, with S and D for $ in Europe.
Analysis. How do economic variables affect the real exchange
rate? Separate from impact on interest rates.
Fig. 6-8 p. 152. Determination of the Real Exchange Rate,
Viewed as Supply and Demand for Dollars in Europe
==
Supply of Dollars:
from net capital outflows from US
Fig. 6-8 p. 152. Determination of the
Real Exchange Rate, viewed as supply
and demand for dollars in Europe.
Demand for dollars:
Europe needs dollars to
pay for its imports, which
are US net exports.
(See discussion alongside the graph in the textbook).
---===========
Quantity of US Dollars
Fig 6-9, p. 153. Impact of Expansionary Fiscal
Policy on the RER
If G increases, NX falls: same result as Figure 6.3. This shows x-rate.
Fig. 6-10 p. 154. The Impact of Expansionary Fiscal
Policy Overseas on the RER
Fig 6-9, p. 153. Impact of Expansionary
Fiscal Policy on the RER.
If G increases, savings falls, raising
equilibrium RER.
Or if T falls, then S = Ybar-C-Gbar, so C
increases, and S falls, and so S-I moves
left.
Fig. 6-10 p. 154. The Impact of
Expansionary Fical Policy Overseas on
the RER: will raise world interest rate
(r*1 →r*2) , lowering domestic
investment. This will increase S-I,
lowering ε, raising NX. (Keynesian
impact on NX is clear).
6
Fig 6-11 p. 155. The Impact of an Increase in
Investment on the RER
Fig 1-12 p. 134. Impact of Protectionism on the RER
Fig 6-11 p. 155. The Impact of an
increase in domestic investment (due to
an investment tax credit or new tech) on
the RER.
S-I falls, raising RER., lowering NX.
(Increase in investment would raise
demand and imports).
Fig 5-12 p. 156. Impact of
Protectionism on the RER.
If tariffs increase, NX moves right, RER
rises ($ appreciates).
Notes that NX doesn’t change—Ybar.
Would argue against protectionism.
Or, taste change from Honda to Fords
Determinants of the nominal exchange rate.
Write e = ε x (P*/P)
Or %Δ e = %Δ ε + %Δ P* - %Δ P
Or %Δ e = %Δ ε +(π* - π)
Fig. 6-13 p. 158. Inflationary Differentials and
the Nominal Exchange Rate
Graphing %∆e and (π* - π), which is related to
%∆e = %∆ ε + (π* - π), supposing %∆ ε is small. (p. ?).
Fig. 6-13 p. 158.
Inflationary Differentials and the
Nominal Exchange Rate
Suggestion that RER is relatively fixed,
and high inflation countries have
depreciations.
Law of one price... goods sell for same prices in different
locations. Relates to purchasing power parity.
Fig 6-14 p. 159. Purchasing Power Parity
Fig 6-14 p. 159.
Purchasing Power Parity
Law of one price suggests that RER is
constant, or that NX is flat.
Suggests limitations are: speed of
adjustment, non-traded goods.
7
Table 5-2 p. 140.
Big Macs and PPP
Table 6-2 p. 161. Big Macs and PPP
Final comment is that the US is rather a large open economy.
Appendix works that out in detail.
Homework p. 143
Homework p 151
1. Use model of SOE to predict what will happen if:
a. A fall in consumer confidence reduces consumption, raises saving
b. Taste change leads us to want more Toyotas, fewer Fords
c. Introduction of automatic teller machines lowers demand for M.
3. Town of Leverett is an SOE. A change in fashion results in a decline
in demand for their exports.
What happens to Leverett exports, saving, interest rate, exchange rate
Will this encourage or discourage foreign travel from Leverettines.
What could the L. gov’t do to taxes, to maintain previous x-rate?
1.Use model of SOE to predict what will happen if:
a. A fall in consumer confidence reduces consumption, raises
saving
b. Taste change leads us to want more Toyotas, fewer Fords
c. Introduction of automatic teller machines lowers demand for M.
3. Town of Leverett is an SOE. A change in fashion results in a
decline in demand for their exports.
What happens to Leverett exports, saving, interest rate, exchange
rate?
Will this encourage or discourage foreign travel from Leverettines.
What could the L. gov’t do to taxes, to maintain previous x-rate?
APPENDIX
8
Figure 5.15 P. 154 How the Net Capital Outflow
Depends on the Interest Rate
Figure 5.16 p. 154 Two Special Cases
Figure 5.15 P. 154 How the Net Capital
Outflow Depends on the Interest Rate
Figure 5.16 p. 154 Two Special Cases.
Closed economy, CF=0, and is independent of
real interest rates
SOE, CF is unlimited at r*
Mankiw: Macroeconomics, Seventh Edition
Figure 5.17 p. 156. The Market for Loanable
Funds in the Large Open Economy
Figure 5.17 p. 156. The Market for Loanable
Funds in the Large Open Economy
(Loanable funds on the horizontal axis)
Figure 5.18 p. 156. The Market for ForeignCurrency Exchange in the Large Open
Economy
Figure 5.18 p. 156. The Market for ForeignCurrency Exchange in the Large Open
Economy
(Net exports on the horizontal axis.
Figure 5.19 p. 157. The Equilibrium in the Large Open Economy
Figure 5.19 p. 157. The Equilibrium in the
Large Open Economy
9
Figure 5.20 p. 159. A Reduction in National
Saving in the Large Open Economy
Figure 5.21 p. 159. An Increase in Investment Demand
in the Large Open Economy
Figure 5.20 p. 159. A Reduction in National
Saving in the Large Open Economy.
If G increases, National savings declines,
interest rates increase, this reduces net capital
outflow, which raises (appreciates) the RER and
lowers net exports.
Can be seen as a combination of closed
economy and a Small open economy.
Figure 5.21 p. 159. An Increase in Investment
Demand in the Large Open Economy.
If I increases because of lower business taxes,
the interest rates rise, capital outflow falls, the
RER increases/appreciates, and net exports fall.
2010 by Worth Publishers
Figure 5.22 p. 160 An Import Restriction in the
Large Open Economy
Figure 5.22 p. 160 An Import Restriction in the
Large Open Economy
Mankiw: Macroeconomics, Seventh Edition
Figure 5.23 p. 161. A Fall in the Net Capital
Outflow in the Large Open Economy
Figure 5.23 p. 161. A Fall in the Net Capital
Outflow in the Large Open Economy
Mankiw: Macroeconomics, Seventh Edition
Copyright © 2010 by Worth Publishers