BUS 530: ECONOMIC CONDITIONS ANALYSIS LECTURE: 4 Classical Theory: The Economy in the Long Run

1. BUS 530: ECONOMIC CONDITIONS ANALYSIS LECTURE: 4 Classical Theory: The Economy in the Long Run The Open Economy

2. Introduction • accounting identities for the open economy • the small open economy model • what makes it “small” • how the trade balance and exchange rate are determined • how policies affect trade balance & exchange rate CHAPTER 5 The Open Economy

3. Trade-GDP ratio, selected countries, 2010(Imports + Exports) as a percentage of GDP CHAPTER 5 The Open Economy

4. In an Open Economy, • spending need not equal output • saving need not equal investment CHAPTER 5 The Open Economy

5. Preliminaries superscripts: d = spending on domestic goods f = spending on foreign goods EX = exports = foreign spending on domestic goods IM = imports = Cf+ If+ Gf= spending on foreign goods NX = net exports (a.k.a. the “trade balance”) = EX – IM CHAPTER 5 The Open Economy

6. GDP = Expenditure on Domestically Produced Goods and Services CHAPTER 5 The Open Economy

7. Y = C + I + G + NX net exports domestic spending output The National Income Identity in an Open Economy or, NX= Y– (C+ I + G) CHAPTER 5 The Open Economy

8. Trade Surpluses and Deficits NX = EX – IM = Y– (C+ I + G ) • trade surplus:output > spending and exports > imports Size of the trade surplus = NX • trade deficit:spending > output and imports > exports Size of the trade deficit = –NX CHAPTER 5 The Open Economy

9. U.S. Net Exports, 1950-2006

10. Bangladesh Net Exports, 2000-2010 CHAPTER 5 The Open Economy

11. 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 CHAPTER 5 The Open Economy

12. The Link Between Trade & Capital 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 ). CHAPTER 5 The Open Economy

13. International Flows of Goods and Capital: Summary This table shows the three outcomes that an economy can experience

14. An open-economy version of the loanable funds model from Chapter 3. Includes many of the same elements: production function consumption function investment function exogenous policy variables Saving and Investment in a Small Open Economy CHAPTER 5 The Open Economy

15. r S, I National Saving: The Supply of Loanable Funds As in Lecture 2,national saving does not depend on the interest rate CHAPTER 5 The Open Economy

16. Assumptions : 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 CHAPTER 5 The Open Economy

17. r I(r) S, I Investment: The Demand for Loanable Funds Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate… …determines the country’s level of investment. r* I(r*) CHAPTER 5 The Open Economy

18. r rc I(r) S, I If the Economy were Closed… …the interest rate would adjust to equate investment and saving: CHAPTER 5 The Open Economy

19. r r* rc I(r) S, I I1 But in a Small Open Economy… the exogenous world interest rate determines investment… Trade surplus NX …and the difference between saving and investment determines net capital outflow and net exports CHAPTER 5 The Open Economy

20. Next, Three Experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand CHAPTER 5 The Open Economy

21. r NX I(r) S, I 1. Fiscal Policy at Home 2. …but when a fiscal expansion reduces saving.. 1. This economy begins with balanced trade 3. ..a trade deficit results CHAPTER 5 The Open Economy

22. Budget deficit (right scale) Net exports (left scale) US: NX and the federal budget deficit (% of GDP), 1960-2006 4% 8% 6% 2% 4% 0% 2% -2% 0% -4% -2% -6% -4% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 slide 21

23. Bangladesh: NX and The Budget Deficit (% of GDP), 2000-2010 CHAPTER 5 The Open Economy

24. r NX I(r) S, I 2. Fiscal Policy Abroad Expansionary fiscal policy abroad raises the world interest rate. Results: CHAPTER 5 The Open Economy

25. r S NX1 I(r)1 S, I I1 3.An Increase in Investment Demand 2. ..leads to a trade deficit 1. An increase in investment demand I(r) 2 CHAPTER 5 The Open Economy

26. Class Excercise Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. CHAPTER 5 The Open Economy

27. e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar) The Nominal Exchange Rate CHAPTER 5 The Open Economy

28. A few Exchange Rates, as of April 2012 CHAPTER 5 The Open Economy

29. the lowercase Greek letter epsilon The Real Exchange Rate = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac) ε CHAPTER 5 The Open Economy

30. The Economist’s Big Mac index July 2009 CHAPTER 5 The Open Economy

31. Understanding the Units of ε ε CHAPTER 5 The Open Economy

32. ε ~ McZample ~ • one good: Big Mac • price in Japan: P* = 200 Yen • price in USA: P = $2.50 • nominal exchange rate e = 120 Yen/$ To buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy 1.5 Japanese Big Macs. CHAPTER 5 The Open Economy slide 31

33. 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 εis the relative price of one country’s output in terms of the other country’s output CHAPTER 5 The Open Economy

34. εBangladesh goods become more expensive relative to foreign goods  EX, IM  NX How NXdepends on ε CHAPTER 5 The Open Economy

35. Trade-weighted real exchange rate index Net exports(left scale) U.S. Net Exports and the Real Exchange Rate, 1973-2006 3% 140 2% 120 1% 100 0% -1% (March 1973 = 100) 80 (% of GDP) -2% 60 -3% NX -4% 40 Index -5% 20 -6% -7% 0 1973 1977 1981 1985 1989 1993 1997 2001 2005 CHAPTER 5 The Open Economy

36. The Net Exports Function • The net exports function reflects this inverse relationship between NX and ε: NX = NX(ε) CHAPTER 5 The Open Economy

37. ε So Bangladesh net exports will be high When ε is relatively low, Bangladesh goods are relatively inexpensive ε1 NX(ε) 0 NX NX(ε1) The NX Curve for the Bangladesh. CHAPTER 5 The Open Economy

38. At high enough values ofε, Bangladesh goods become so expensive that ε ε2 we export less than we import NX(ε) 0 NX NX(ε2) The NX Curve for the Bangladesh CHAPTER 5 The Open Economy

39. 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) • I is determined by the world interest rate r* • So, ε must adjust to ensure CHAPTER 5 The Open Economy

40. ε NX(ε) NX How ε is Determined Neither Snor I depend on ε, so the net capital outflow curve is vertical. ε1 ε adjusts to equate NXwith net capital outflow, S-I. NX1 CHAPTER 5 The Open Economy

41. ε NX(ε) NX 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. ε1 NX1 CHAPTER 5 The Open Economy

42. Next, Four Experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports CHAPTER 5 The Open Economy

43. ε ε2 ε1 NX(ε) NX NX1 NX2 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. CHAPTER 5 The Open Economy

44. ε ε1 ε2 NX(ε) NX NX2 NX1 2. Fiscal Policy Abroad An increase in r* reduces investment, increasing net capital outflow and the supply of dollars in the foreign exchange market… …causing the real exchange rate to fall and NX to rise. CHAPTER 5 The Open Economy

45. ε ε2 ε1 NX(ε) NX NX1 NX2 3. Increase in Investment Demand An increase in investment reduces net capital outflow and the supply of dollars in the foreign exchange market… …causing the real exchange rate to rise and NX to fall. CHAPTER 5 The Open Economy

46. ε ε2 ε1 NX(ε)2 NX(ε)1 NX NX1 4.Trade Policy to Restrict Imports At any given value of ε, an import quota  IM NX  demand for dollars shifts right Trade policy doesn’t affect S or I, so capital flows and the supply of dollars remain fixed. CHAPTER 5 The Open Economy

47. ε ε2 ε1 NX(ε)2 NX(ε)1 NX NX1 4.Trade Policy to Restrict Imports Results: ε > 0 (demand increase) NX = 0(supply fixed) IM < 0 (policy) EX < 0(rise in ε) CHAPTER 5 The Open Economy

48. The Determinants of the Nominal Exchange Rate • Start with the expression for the real exchange rate: • Solve for the nominal exchange rate: CHAPTER 5 The Open Economy

49. The Determinants of the Nominal Exchange Rate • So e depends on the real exchange rate and the price levels at home and abroad… …and we know how each of them is determined: CHAPTER 5 The Open Economy

50. The Determinants of the Nominal Exchange Rate • Rewrite this equation in growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ): • For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates. CHAPTER 5 The Open Economy