Economics 122a
Open-Economy Macroeconomics
Topics:
1. International issues
2. Balance of payments accounting
3. Saving and investment in the open economy
4. Determination of the exchange rate
What are the major international issues?
• International trade and investment increase productivity and
growth (standard trade and capital theory)
– The need to preserve a free and open trading system
• International spillovers (standard macro)
– Output affected through trade flows
– Financial markets affect exchange rates, interest rates, asset
bubbles and bursts
• Markets cannot manage themselves. This is why nations need
active rules, institutions, and policies:
– Coordinate trade and finance policies (Basel III)
– Manage crises, such as potential Eurozone collapse
– Contain contagion
– International institutions to help prevent destructive “prisoners’
dilemma” equilibria (trade, monetary policy, exchange rates,…)
2
Savings and Investment in a Closed Economy
We will look at the open economy flows in a S-I framework.
We can begin using Mankiw’s loanable funds model (pp. 70—71). This
approach examines the sources and uses of saving and investment.
Do for closed economy first:
Basics:
(1)
Y=C+I+G
(expenditure identity)
(2)
Spriv = Y – T - C
(definition of private saving)
(3)
Sn = Spriv + (T - G)
(definition of national saving)
= Spriv + Sgov
(4)
I = I(r)
(investment equation)
These imply :
(5)
Sn = Spriv + Sgov = I(r)
3
Closed Economy S and I equilibrium
Real interest rate (r)
Sn = Spriv + (T-G) = Spriv + Sgov
r*
Id (r)
I*
S, I
4
Essential balancing property
of Balance of Payments
Current Account
Financial Account
Net Balance
A
-A
0
6
Balance of Payments v. National Accounts
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
7
Balance of Payments, 2012
[Billions of current $]
Goods and services
Exports
Imports
Net income of foreign investments
Unilateral transfers, net
-560
2,211
-2,745
224
-130
Balance on Current Account
Net change in assets
Central banks
Other
Statistical discrepancy
-440
446
390
56
Balance on Financial Account
Net exports
* I have omitted "capital account," which is trivial in $ terms.
-6
440
-547
Globalization in trade of goods and services, US
.20
Imports/GDP
Exports/GDP
.16
Rising trend
.12
.08
.04
.00
50
55
60
65
70
75
80
85
90
95
00
05
10
Savings and Investment in the Open Economy
ACCOUNTING:
Y = output = C + I + G + NX
Y = income = C + Spriv + T
I + NX = Spriv + Sgov = Sn
or
NX = Spriv + Sgov – I = Sn – I
10
Classical Small Open Economy
1. Classical economy
• Full employment, flex w and p; this implies that domestic
output is at potential
2. Small open economy
• Too small to affect goods prices or financial markets
3. Mobile financial capital
• free flow of funds among countries
• Investors therefore compare domestic and foreign interest
rates (rd, rw )
• In small economy, rd = rw = world interest rate
11
Open Economy S and I equilibrium
Real interest rate (r)
Sn = Spriv + (T-G)
Net exports > 0
r*=rW
China,
Japan,
OPEC
today
Id (r)
I*
S, I
12
Open Economy S and I equilibrium
Real interest rate (r)
Sn = Spriv + (T-G)
US today;
LDCs
classically
rW
Net exports < 0
Id (r)
I*
S, I
13
Shock I: Increase in world interest rate
Real interest rate (r)
rW’
rW
S = Sp + (T-G)
NX**
NX*
Id (r)
I**
I*
S, I
14
Shock II: Increase in G
Real interest rate (r)
S*
S**
NX*>0
rW
NX**<0
Id (r)
I*
S, I
15
Key insight: Financial dog wags
trade tail
Tail of
finance
Dog of trade
Open Economy Macro:
The transmission mechanism
through the real exchange rate
The Transmission Mechanism in Open Economy Macro
We saw that changes in domestic saving and
investment, or changes in world interest rates, or
domestic risk premiums would affect net exports.
How does that happen?
Through the adjustment of the real exchange rate.
Let see how.
18