Lecture03_note - Macroeconomics II Lecture 3 Classical...

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Unformatted text preview: Macroeconomics II Lecture 3 Classical theory: the open economy in the long run Macroeconomics Instructor: Dang Vu University of Economics and Business - VNU In this lecture, you will learn… accounting identities for the open economy the small open economy model what makes it “small” h th t d b l how the trade balance and exchange rate are d h t determined how policies affect trade balance & exchange rate LECTURE 3 The open economy in the long run slide 1 In an open economy, spending need not equal output saving need not equal investment LECTURE 3 The open economy in the long run slide 3 1 Macroeconomics II Preliminaries superscripts: d = spending on domestic goods f = spending on foreign goods C C d C f I Id If G G d G f EX = exports = t foreign spending on domestic goods IM = imports = C f + I f + G f = spending on foreign goods NX = net exports (a.k.a. the “trade balance”) = EX – IM LECTURE 3 The open economy in the long run slide 4 GDP = expenditure on domestically produced g & s Y C d I d G d EX (C C f ) (I I f ) (G G f ) EX C I G EX (C f I f G f ) C I G EX IM C I G NX LECTURE 3 The open economy in the long run slide 5 The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G ) domestic spending net exports output LECTURE 3 The open economy in the long run slide 6 2 Macroeconomics II Trade surpluses and deficits NX = EX – IM = Y – (C + I + G ) trade surplus: output > spending and exports > imports Size f the t d Si of th trade surplus = NX l trade deficit: spending > output and imports > exports Size of the trade deficit = –NX LECTURE 3 The open economy in the long run slide 7 International capital flows Net capital outflow =S –I = net outflow of “loanable funds” = net purchases of foreign assets the country’s purchases of foreign assets minus foreign purchases of domestic assets When S > I, country is a net lender When S < I, country is a net borrower LECTURE 3 The open economy in the long run slide 9 The link between trade & cap. flows NX = Y – (C + I + G ) implies NX = (Y – C – G ) – I = S – I trade balance = net capital outflow Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ). LECTURE 3 The open economy in the long run slide 10 3 Macroeconomics II “The world’s largest debtor nation” U.S. has had large trade deficits, been a net borrower each year since the early 1980s. As of 12/31/2005: U.S. residents owned $10.0 trillion worth of $ foreign assets Foreigners owned $12.7 trillion worth of U.S. assets U.S. net indebtedness to rest of the world: $2.7 trillion--higher than any other country, hence U.S. is the “world’s largest debtor nation” LECTURE 3 The open economy in the long run slide 11 Saving and investment in a small open economy An open-economy version of the loanable funds model from Lecture 2. Includes many of the same elements: production function consumption function Y Y F (K , L ) C C (Y T ) investment function I I (r ) exogenous policy variables G G , T T LECTURE 3 The open economy in the long run slide 12 National saving: The supply of loanable funds r S Y C (Y T ) G As in Lecture 2, g national saving does not depend on the interest rate S LECTURE 3 S, I The open economy in the long run slide 13 4 Macroeconomics II Assumptions re: Capital flows a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.) b. perfect capital mobility: no restrictions on international trade in assets c. economy is small: cannot affect the world interest rate, denoted r* a & b imply r = r* c implies r* is exogenous LECTURE 3 The open economy in the long run slide 14 Investment: The demand for loanable funds Investment is still a downward-sloping function of the interest rate, but the exogenous o d e es a e world interest rate… …determines the country’s level of investment. I (r ) r r* I (r* ) LECTURE 3 S, I The open economy in the long run slide 15 If the economy were closed… r …the interest rate would adjust to equate investment and saving: S rc I (r ) I (rc ) S LECTURE 3 The open economy in the long run S, I slide 16 5 Macroeconomics II But in a small open economy… the exogenous world interest rate determines investment… …and the difference between saving and investment determines net capital outflow and net exports LECTURE 3 r S NX r* rc I (r ) S, I I1 The open economy in the long run slide 17 Next, three experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand LECTURE 3 The open economy in the long run slide 18 1. Fiscal policy at home r An increase in G or decrease in T reduces saving. r1* S 2 S1 NX2 NX1 Results: I 0 I (r ) NX S 0 I1 LECTURE 3 The open economy in the long run S, I slide 19 6 Macroeconomics II 2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. r NX2 r2* S1 NX1 r1* Results: I 0 I (r ) NX I 0 LECTURE 3 S, I I (r1* ) I (r2* ) The open economy in the long run slide 21 3. An increase in investment demand r S r* EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. LECTURE 3 NX1 I (r )1 I1 The open economy in the long run S, I slide 22 The nominal exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar) LECTURE 3 The open economy in the long run slide 24 7 Macroeconomics II A few exchange rates, as of 7/14/06 country exchange rate Euro 0.79 Euro/$ Indonesia 9,105 Rupiahs/$ Japan 116.3 116 3 Yen/$ Mexico 11.0 Pesos/$ Russia 27.0 Rubles/$ South Africa 7.2 Rand/$ U.K. 0.54 Pounds/$ The open economy in the long run LECTURE 3 slide 25 The real exchange rate ε = real exchange rate, the lowercase Greek letter G kl epsilon the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac) The open economy in the long run LECTURE 3 slide 26 Understanding the units of ε ε e P P * (Yen per $) ($ per unit U.S. goods) Yen per unit Japanese goods Yen per unit U.S. goods Yen per unit Japanese goods Units of Japanese goods per unit of U.S. goods LECTURE 3 The open economy in the long run slide 27 8 Macroeconomics II ~ McZample ~ one good: Big Mac price in Japan: P* = 200 Yen price in USA: P = $2.50 nominal exchange rate e = 120 Yen/$ ε LECTURE 3 e P P * 120 $2.50 1 .5 200 Yen To buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy 1.5 Japanese Big Macs. The open economy in the long run slide 28 ε in the real world & our model In the real world: We can think of ε as the relative price of a basket of domestic goods in terms of a basket of foreign goods In our macro model: There’s just one good, “output.” So ε is the relative price of one country’s output in terms of the other country’s output LECTURE 3 The open economy in the long run slide 29 How NX depends on ε ε U.S. goods become more expensive relative to foreign goods EX, IM NX LECTURE 3 The open economy in the long run slide 30 9 Macroeconomics II U.S. net exports and the real exchange rate, 1973-2006 140 Trade-weighted real exchange rate index 2% 120 NX (% of GDP) G 1% 100 0% -1% 80 -2% 60 -3% -4% 40 Net exports (left scale) -5% 973 Index (March 19 = 100) 3% 20 -6% -7% 0 1973 1977 LECTURE 3 1981 1985 1989 1993 1997 2001 2005 The open economy in the long run slide 31 The net exports function The net exports function reflects this inverse relationship between NX and ε : NX = NX(ε ) LECTURE 3 The open economy in the long run slide 32 The NX curve for the U.S. ε When ε is relatively low, U.S. goods are relatively inexpensive so U.S. net exports will be high ε1 NX (ε) 0 LECTURE 3 NX(ε1) The open economy in the long run NX slide 33 10 Macroeconomics II The NX curve for the U.S. ε ε2 At high enough values of ε, U.S. goods become so expensive that we export p less than we import NX (ε) LECTURE 3 NX 0 NX(ε2) The open economy in the long run slide 34 How ε is determined The accounting identity says NX = S – I We saw earlier how S – I is determined: S depends on domestic factors (output, fiscal policy variables etc) variables, I is determined by the world interest rate r * So, ε must adjust to ensure NX (ε ) S I (r *) LECTURE 3 The open economy in the long run slide 35 How ε is determined Neither S nor I depend on ε, so the net capital outflow curve is vertical. ε adjusts to ε S 1 I (r *) ε1 equate NX with net capital outflow, S I. LECTURE 3 The open economy in the long run NX(ε ) NX 1 NX slide 36 11 Macroeconomics II Interpretation: Supply and demand in the foreign exchange market demand: Foreigners need dollars to buy U.S. net exports. supply: Net capital outflow (S I ) is the supply of dollars to be invested abroad. LECTURE 3 S 1 I (r *) ε ε1 NX(ε ) NX NX 1 The open economy in the long run slide 37 Next, four experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports LECTURE 3 The open economy in the long run slide 38 1. Fiscal policy at home A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars in the foreign exchange market… …causing the real exchange rate to rise and NX to fall. LECTURE 3 ε S 2 I (r *) S 1 I (r *) ε2 ε1 NX(ε ) NX 2 The open economy in the long run NX 1 NX slide 39 12 Macroeconomics II 2. Fiscal policy abroad An increase in r* reduces investment, increasing net capital outflow and the supply of dollars in the foreign exchange market… ε S 1 I (r 2 * ) ε1 ε2 NX(ε ) …causing the real exchange rate to fall and NX to rise. LECTURE 3 S 1 I (r1 *) NX NX 2 NX 1 The open economy in the long run slide 40 3. Increase in investment demand An increase in investment reduces net capital outflow and the supply of dollars i th f d ll in the foreign exchange market… ε S1 I1 ε2 ε1 …causing the real exchange rate to rise and NX to fall. CHAPTER 5 S1 I 2 NX(ε ) NX 2 NX 1 NX The Open Economy slide 41 4. Trade policy to restrict imports At any given value of ε ε, an import quota IM NX demand for ε2 dollars shifts right ε1 Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remain fixed. LECTURE 3 S I NX (ε )2 NX (ε )1 NX1 The open economy in the long run NX slide 42 13 Macroeconomics II 4. Trade policy to restrict imports Results: S I ε ε > 0 (demand increase) ε2 NX = 0 (supply fixed) ε1 NX (ε )2 IM < 0 (policy) NX (ε )1 EX < 0 (rise in ε ) LECTURE 3 NX1 The open economy in the long run NX slide 43 Purchasing Power Parity (PPP) Two definitions: A doctrine that states that goods must sell at the same (currency-adjusted) price in all countries. The nominal exchange rate adjusts to equalize g j q the cost of a basket of goods across countries. Reasoning: arbitrage, the law of one price LECTURE 3 The open economy in the long run slide 48 Purchasing Power Parity (PPP) PPP: e P = P* Cost of a basket of domestic goods in goods, foreign currency. Cost of a basket of foreign goods, in foreign currency. Cost of a basket of domestic goods, in domestic currency. Solve for e : e = P*/ P PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels. LECTURE 3 The open economy in the long run slide 49 14 Macroeconomics II Purchasing Power Parity (PPP) If e = P*/P, then ε e P P* P * 1 * P P P and the NX curve is horizontal: ε SI ε =1 Under PPP, changes in (S – I ) have no impact on ε or e. NX NX LECTURE 3 The open economy in the long run slide 50 Does PPP hold in the real world? No, for two reasons: 1. International arbitrage not possible. nontraded goods transportation costs 2. Different countries’ goods not perfect substitutes. Nonetheless, PPP is a useful theory: It’s simple & intuitive In the real world, nominal exchange rates tend toward their PPP values over the long run. LECTURE 3 The open economy in the long run slide 51 CASE STUDY: The Reagan deficits revisited 1970s 1980s actual change closed economy small open economy G–T 2.2 3.9 S 19.6 17.4 r 1.1 6.3 no change I 19.9 19.4 no change NX -0.3 -2.0 no change ε 115.1 129.4 no change Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index. LECTURE 3 The open economy in the long run slide 52 15 Macroeconomics II The U.S. as a large open economy So far, we’ve learned long-run models for two extreme cases: closed economy small open economy A large open economy – lik th U S – f ll l like the U.S. falls between these two extremes. The results from large open economy analysis are a mixture of the results for the closed & small open economy cases. For example… LECTURE 3 The open economy in the long run slide 53 Large open economy LECTURE 3 The open economy in the long run slide 54 An expansionary fiscal policy LECTURE 3 The open economy in the long run slide 55 16 Macroeconomics II A fiscal expansion in three models A fiscal expansion causes national saving to fall. The effects of this depend on openness & size: closed economy large open economy r rises rises, but not as much as in closed economy no change I falls falls, but not as much as in closed economy no change NX no change falls, but not as much as in small open economy falls LECTURE 3 small open economy The open economy in the long run slide 56 Increase in investment demand LECTURE 3 The open economy in the long run slide 57 Import restriction LECTURE 3 The open economy in the long run slide 58 17 Macroeconomics II Fall in Net Capital Outflow LECTURE 3 The open economy in the long run slide 59 Summary Net exports--the difference between exports and imports a country’s output (Y ) and its spending (C + I + G) Net capital outflow equals purchases of foreign assets minus foreign purchases of the country’s assets the difference between saving and investment LECTURE 3 The open economy in the long run slide 60 Summary National income accounts identities: Y = C + I + G + NX trade balance NX = S I net capital outflow Impact of policies on NX : NX increases if policy causes S to rise or I to fall NX does not change if policy affects neither S nor I. Example: trade policy LECTURE 3 The open economy in the long run slide 61 18 Macroeconomics II Summary Exchange rates nominal: the price of a country’s currency in terms of another country’s currency real: the price of a country’s g p y goods in terms of another country’s goods The real exchange rate equals the nominal rate times the ratio of prices of the two countries. LECTURE 3 The open economy in the long run slide 62 Summary How the real exchange rate is determined NX depends negatively on the real exchange rate, other things equal The real exchange rate adjusts to equate g j q NX with net capital outflow LECTURE 3 The open economy in the long run slide 63 Summary How the nominal exchange rate is determined e equals the real exchange rate times the country’s price level relative to the foreign price level. For a given value of the real exchange rate, the percentage change in the nominal exchange rate equals the difference between the foreign & domestic inflation rates. LECTURE 3 The open economy in the long run slide 64 19 ...
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This note was uploaded on 10/30/2010 for the course INTERNATIO 8989989 taught by Professor 90 during the Spring '10 term at Mt. Vernon Nazarene.

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