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Open Economy Macroeconomics

Open Economy Macroeconomics. The Final Frontier. Closed Economy Macroeconomics. Y = C + I + G (Goods Market) S = I + (G-T) (Asset Market) There is only one medium of exchange ($). Open Economy Macroeconomics. NX = Exports – Imports NX < 0 : Trade Deficit NX > 0 : Trade Surplus

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Open Economy Macroeconomics

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  1. Open Economy Macroeconomics The Final Frontier

  2. Closed Economy Macroeconomics • Y = C + I + G (Goods Market) • S = I + (G-T) (Asset Market) • There is only one medium of exchange ($)

  3. Open Economy Macroeconomics • NX = Exports – Imports • NX < 0 : Trade Deficit • NX > 0 : Trade Surplus • Y = C + I + G + NX • S = I + (G-T) + NX

  4. Output/Income in the Open Economy • Trade Deficits imply NX< 0 • Therefore, Y- (C + I + G) = NX < 0 • Countries that run trade deficits are consuming more that they earn

  5. Savings in the Open Economy • Again, a trade deficit implies NX<0 • Therefore, S – (I – (G-T)) = NX < 0 • A country with a trade deficit is borrowing from the rest of the world • That is, foreign countries are acquiring domestic assets

  6. Balance of Payments Accounting • Anything that we buy or sell to the rest of the world must be paid for. • The current account (CA) tracks the flow of goods and services between the US and the rest of the world • The capital & financial account tracks the payments for those goods & services (KFA) • CA + KFA = 0

  7. The Current Account • Any transaction that represents a flow of funds out of the US is represented by debit (-). Transactions that represent a flow of money into the US are represented by a credit(+)

  8. The Current Account • Any transaction that represents a flow of funds out of the US is represented by debit (-). Transactions that represent a flow of money into the US are represented by a credit(+) • Net Exports of Goods and Services Exports (+) Imports (-) • Net Income From Abroad (NFP) Income Earned by US nationals abroad (+) Income earned by foreign nationals in the US (-) • Net Unilateral Transfers Payments from foreign countries (+) Payments to foreign Countries (-)

  9. The US Current Account (in Billions of $s) • Net Exports of Goods & Services • Services: $52 • Goods: -$652 -$600 • Net Factor Payments: -$12 • Net Unilateral Transfers: -$72 Current Account Balance: -$684

  10. The Capital & Financial Account • Again, any transaction that represents funds flowing into (out of) the US are credits (debits) in the KFA

  11. The Capital & Financial Account • Again, any transaction that represents funds flowing into (out of) the US are credits (debits) in the KFA • Financial assets Foreign acquisition of US assets (+) US acquisition of foreign assets (-) • Official Reserve Assets Foreign acquisition of US reserve assets (+) US acquisition of foreign reserve assets (-)

  12. The US Capital & Financial Account (in billions of $s) • Private Assets • Foreign acquisition of US assets: $1,060 • US acquisition of foreign assets: -$472 $588 • Official Reserve Assets • Foreign acquisition of US ORA: $22 • US acquisition of foreign ORA: $2 $24 • US KFA account balance: $612 • Note: CA (-$684) + KFA ($612) = -$72 (statistical discrepancy)

  13. Example • Suppose that you purchase a case of French wine for $1500 (for simplicity, assume that you pay with cash)

  14. Current Account Exports Goods: Services: Imports Goods: -$1500 Services: Net Factor Income: Net Unilateral Transfers: Capital & Financial Account Financial assets: Foreign acquisition of US assets: US acquisition of foreign assets Official Reserve Assets Foreign acquisition of US ORA: US acquisition of foreign ORA: Balance of Payments Accounts

  15. Example • Suppose that you purchase a case of French wine for $1500 (for simplicity, assume that you pay with cash) • Case #1: The French wine distributor uses the $1500 to purchase a computer from Dell

  16. Current Account Exports Goods: $1500 Services: Imports Goods: -$1500 Services: Net Factor Income: Net Unilateral Transfers: Capital & Financial Account Financial assets: Foreign acquisition of US assets: US acquisition of foreign assets Official Reserve Assets Foreign acquisition of US ORA: US acquisition of foreign ORA: Balance of Payments Accounts

  17. Example • Suppose that you purchase a case of French wine for $1500 (for simplicity, assume that you pay with cash) • Case #1: The French wine distributor uses the $1500 to purchase a computer from Dell • Case #2: The French wine distributor uses the $1500 to buy a US T-Bill.

  18. Current Account Exports Goods: Services: Imports Goods: -$1500 Services: Net Factor Income: Net Unilateral Transfers: Capital & Financial Account Financial assets: Foreign acquisition of US assets: $1500 US acquisition of foreign assets: Official Reserve Assets Foreign acquisition of US ORA: US acquisition of foreign ORA: Balance of Payments Accounts

  19. Example • Suppose that you purchase a case of French wine for $1500 (for simplicity, assume that you pay with cash) • Case #1: The French wine distributor uses the $1500 to purchase a computer from Dell • Case #2: The French wine distributor uses the $1500 to buy a US T-Bill. • Case #3: The French wine distributor uses the $1500 to buy Euros from the Federal Reserve

  20. Current Account Exports Goods: Services: Imports Goods: -$1500 Services: Net Factor Income: Net Unilateral Transfers: Capital & Financial Account Financial assets: Foreign acquisition of US assets: US acquisition of foreign assets: Official Reserve Assets Foreign acquisition of US ORA: $1500 US acquisition of foreign ORA: Balance of Payments Accounts

  21. Payments to Iraq • In 2003, The US government approved an $87 billion aid package to Iraq. How will this be reflected in the BOP accounts?

  22. Current Account Exports Goods: Services: Imports Goods: Services: Net Factor Income: Net Unilateral Transfers: -$87B Capital & Financial Account Financial assets: Foreign acquisition of US assets: US acquisition of foreign assets: Official Reserve Assets Foreign acquisition of US ORA: US acquisition of foreign ORA: Balance of Payments Accounts

  23. Payments to Iraq • In 2003, the US government approved an $87 billion aid package to Iraq. How will this be reflected in the BOP accounts? • The $87 billion payment is represented by a debit under unilateral transfers • Most of that money was used to pay US soldiers and US reconstruction companies (around $70B)

  24. Current Account Exports Goods: Services: Imports Goods: Services: Net Factor Income: $70B Net Unilateral Transfers: -$87B Capital & Financial Account Financial assets: Foreign acquisition of US assets: US acquisition of foreign assets: Official Reserve Assets Foreign acquisition of US ORA: US acquisition of foreign ORA: Balance of Payments Accounts

  25. Payments to Iraq • The US government just approved an $87 billion aid package to Iraq. How will this be reflected in the BOP accounts? • The $87 billion payment is represented by a debit under unilateral transfers • Most of that money is being used to pay US soldiers and US reconstruction companies (around $70B) • The rest will be used to buy US goods or US assets (either by Iraq or by other countries)

  26. Current Account Exports Goods: $5B Services: $7B Imports Goods: Services: Net Factor Income: $70B Net Unilateral Transfers: -$87B Capital & Financial Account Financial assets: Foreign acquisition of US assets: $5B US acquisition of foreign assets: Official Reserve Assets Foreign acquisition of US ORA: US acquisition of foreign ORA: Balance of Payments Accounts

  27. Payments to Iraq • The US government just approved an $87 billion aid package to Iraq. How will this be reflected in the BOP accounts? • The $87 billion payment is represented by a debit under unilateral transfers • Most of that money is being used to pay US soldiers and US reconstruction companies (around $70B) • The rest will be used to buy US goods or US assets (either by Iraq or by other countries) • How would the BOPs change if this $87B was a loan rather than aid?

  28. Current Account Exports Goods: $5B Services: $7B Imports Goods: Services: Net Factor Income: $70B Net Unilateral Transfers: Capital & Financial Account Financial assets: Foreign acquisition of US assets: $5B US acquisition of foreign assets: -$87B Official Reserve Assets Foreign acquisition of US ORA: US acquisition of foreign ORA: Balance of Payments Accounts

  29. The Balance of Payments • There are two possible definitions for the balance of payments: • Current Account + Net foreign acquisition of US assets -$684 + $588 = -$96 • Net acquisition of Foreign Official Reserve Assets: $24 • The difference is the statistical discrepancy

  30. Trade Deficits vs. Balance of Payments Deficits • The US currently has a growing trade deficit. • There more demand for foreign currencies (to buy foreign goods) that demand for US dollars (to buy US goods). Does this mean that the dollar should depreciate?

  31. US Balance of Payments

  32. US Balance of Payments

  33. US Balance of Payments

  34. US Trade Weighted Exchange Rate Index

  35. Exchange Rates • The nominal exchange rate reflects the relative value of one currency in terms of another. • BE CAREFUL!!!! WATCH THE UNITS!!!!

  36. Exchange Rates • The nominal exchange rate reflects the relative value of one currency in terms of another. • BE CAREFUL!!!! WATCH THE UNITS!!!! • If the exchange rate (e) is defined as the dollar price of a unit of foreign currency for example, 1 Euro = $1.33 • An increase (decrease) in e represents a dollar depreciation (appreciation)

  37. Exchange Rates • The nominal exchange rate reflects the relative value of one currency in terms of another. • BE CAREFUL!!!! WATCH THE UNITS!!!! • If the exchange rate (e) is defined as the foreign currency price of a dollar for example, $1 = E .75 • An increase (decrease) in e represents a dollar appreciation (depreciation)

  38. The Dollar vs. The Euro

  39. Cross Rates • Note that most currency prices are related to the dollar. For example, the British pound sells for $1.93/GBP • We can use any two dollar exchange rates to find the “cross rates” (non-dollar exchange rates)

  40. Cross Rates • Note that most currency prices are related to the dollar. For example, the British pound sells for $1.93/GBP • We can use any two dollar exchange rates to find the “cross rates” (non-dollar exchange rates) • For example, if the exchange rate for Japanese yen is Y109.62/$, then the price of a GBN in Yen is E = 102(Y/$) * 1.93 ($/GBP) = 196.86(Y/GBP)

  41. Adding Net Exports to Capital Markets • Without access to world capital markets, a country’s private saving is the sole source of funds. Therefore, the domestic interest rate must adjust to insure that S = I + (G-T) • In this example, the domestic interest rate is equal to 10% and S = I +(G-T) = 300 • What will happen if we expose this country to trade?

  42. Adding Net Exports to Capital Markets • Suppose that the prevailing world (real) interest rate is 6%

  43. Adding Net Exports to Capital Markets • Suppose that the prevailing world interest rate is 6% • At 6%, • S = $100 • I + (G-T) = $500 • NX = $100 - $500 = -$400

  44. Adding Net Exports to Capital Markets • Suppose that the prevailing world interest rate is 14%

  45. Adding Net Exports to Capital Markets • Suppose that the prevailing world interest rate is 14% • S = $500 • I + (G-T) = $100 • NX = $500 - $100 = $400

  46. Where does the world interest rate come from? • Aggregate world savings is the sum of private savings across countries • Aggregate Private Investment and Government Deficits are also summed over all countries • By definition, NX summed over all countries must equal zero. Therefore, at the world equilibrium interest rate, S = I + (G-T) • In this example, r = 11%

  47. Example: An increase in productivity • Suppose that trade is initially balanced. A rise in productivity increases investment demand

  48. Example: An increase in productivity • Suppose that trade is initially balanced. A rise in productivity increases investment demand • In a closed economy, interest rates would rise

  49. Example: An increase in productivity • Suppose that trade is initially balanced. A rise in productivity increases investment demand • In a closed economy, interest rates would rise • In an open economy, the trade deficit would increase. In the case, the deficit increases from zero to -$15,000 • Do interest rates rise at all?

  50. World Capital Markets • A country’s ability to influence world interest rates depends on its size relative to the world economy (recall, global interest rates are determined such that global capital markets clear) • The US makes up roughly 35% of the global economy. Therefore, the US can significantly influence global interest rates (as can Japan, EU, and China) • The rest of the world has little influence unless it acts as a unified group (Latin American Financial Crisis, Asian Crisis)

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