Economics 122aOpen-Economy Macroeconomics

Topics:1. International issues2. Balance of payments accounting3. Saving and investment in the open economy4. Determination of the exchange rate

2

What are the enduring international issues?

• International trade and investment increase productivity and growth (standard trade and capital theory)

• International competition – heightens the process of “creative destruction” – But is resisted by those why are hurt (non-standard trade

theory)• International spillovers (standard macro)

– lead to exports and imports and affect output and employment

– lead to capital flows and affect exchange rates, relative prices, interest rates, asset prices, and produces bubbles and bursts

• Markets cannot manage themselves. This is why nations need active rules, institutions, and policies:– Foreign economic policies on trade and finance– To coordinate policy– International institutions to help prevent destructive

“prisoners’ dilemma” outcomes on trade, capital flows, war, …

World Trade and Growth in the Recession

IMF, World Economics Outlook, 2010

4

What are the today’s issues?

• The Great Recession• Fight off protectionism

– Sinners are everywhere; EU threatens CO2 trade sanctions; recent Chinese actions.

• Financial spillovers– Because of increasingly integrated financial

markets• Markets cannot manage themselves.

– Coordinate risk and regulatory standards for banks (Basel III)

– Contain protectionism through the WTO– Dal with exchange rate protectionism (China?)

Measuring international flows

6

Essential balancing property of Balance of Payments

Current Account AFinancial Account -A

Net Balance 0

7

Balance of Payments v. Real Goods and Services

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

Balance of Payments, 2009

Goods and services -375Exports 1,571Imports -1,946

Net income of foreign investments 121Unilateral transfers, net -125

Balance on Current Account -378

Net change in assets 216Central banks 502Other -286

Statistical discrepancy 162

Balance on Financial Account 378

Net exports -375

* I have omitted "capital account," which is trivial in $ terms.

9

Globalization in trade of goods and services, US

0

4

8

12

16

20

1950 1960 1970 1980 1990 2000

ImportsExports

Impo

rts,

exp

orts

(%

of G

DP

)

Rising trend

10

Overview of analysis

1. Savings-investment accounting2. S, I, and NX determination3. How S, I, and NX determine real exchange

rate4. Small and large open economies

11

Supply and Demand for Loanable Funds

Mankiw (chap 3) shows an alternative derivation of the classical model using the loanable funds. This approach examines the sources and uses of saving and investment. Do for simplest system:

Basics:

(1) Y = C + I (expenditure identity)

(2) S = Y - C (definition of private saving)

(3) I = I(r) (investment equation)

 

These imply : 

(4) S= I(r) 

In this alternative approach, make sure you understand the difference between the savings-investment identity and the savings-investment equilibrium.

12

Recall Closed Economy S and I equilibrium

S, I

Real interest rate (r)

Id (r)

I*

r*

Sn = Spriv + (T-G)

13

Example of disequilibrium for S and I

If there is excess demand for I at r*, then the rate must rise to equilibrate S and I.

This means that planned I at the original interest rate (r0) was excessive.

Note that equilibrating mechanism will differ in different markets – Keynesian mechanism is quantity rather than price.

I(r)

S(r)r

r**

A

B

r*C

14

Savings and Investment in the Open Economy

ACCOUNTING:

Y = output = C + I + G + NXY = income = Yd + T + Sb = C + Spers + Sb + T = C + Spriv+ T

→ I + NX = Spriv + Sgov = Sn

or

NX = Spriv + Sgov – I = Sn – I

15

Classical Open Economy Equilibrium

Now study open-economy equilibrium:

1. Classical economy • Full employment, flex w and p; this implies that

domestic output is at potential2. Small open economy

• Too small to affect goods prices or financial markets3. 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

16

Open Economy S and I equilibrium

S, I

Real interest rate (r)

Id (r)

I*

r*=rW

Net exports > 0

Sn = Spriv + (T-G)

China, Japan,OPEC today

17

Open Economy S and I equilibrium

S, I

Real interest rate (r)

Id (r)

I*

rW

Net exports < 0

Sn = Spriv + (T-G)

US today; LDCs classically

18

Shock I: Increase in world interest rate

S, I

Real interest rate (r)

Id (r)

I*

rW

S = Sp + (T-G)

rW’

I**

NX**

NX*

19

Shock II: Increase in G

S, I

Real interest rate (r)

Id (r)

I*

rW

S** S*

NX**<0

NX*>0

Open Economy Macro:The transmission mechanism

through the real exchange rate

21

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.

Financial Globalization

0

20

40

60

80

100

120

140

1975 1980 1985 1990 1995 2000 2005 2010

US assets abroad (% US GDP)ROW assets in US (% US GDP)

Ass

ets

as %

of U

S G

DP

23

Exchange rates

Foreign-exchange rates are the relative prices of different national monies or currencies.

Convention in Econ 122 and Mankiw: Nominal exchange rate • exchange rates = amount of foreign currency per

unit of domestic currency.• Think Japanese Yen: 100 yen to $.

24

Terminology

For market-determined exchange rates:• An appreciation of a currency is when the value of

the currency rises– e or R rises

• A depreciation of a currency is when the value of the currency falls– e or R falls

For fixed exchange rates:• Price set by government is the “parity.”• A revaluation is an increase in the official parity.• A devaluation is a decrease in the parity.

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Index of US nominal exchange rate (e)

Appreciation

Depreciation

20

40

60

80

100

120

140

1975 1980 1985 1990 1995 2000 2005 2010

26

Real exchange rates

Real exchange rate, R [Mankiw uses ε) R = nominal exchange rate corrected for relative prices

R = e × (p d / p f )= p d / (p f / e)

= domestic prices/foreign prices in a common currency

Note: If you calculate the rate of growth of R, you get

Example of car exchange rate: 100 Yen/$; Toyota = 2,000,000Y; Ford = $20,000; R = 100 * 20000/2000000 = 1 Toyota/Ford

rate of real rate of nominal domestic foreign

appreciation appreciation inflation rate inflation rate

27

Big Mac Real Exchange Rate

R = p d / (p f / e)

Example of Big Mac*Price in Beijing: 13 YuanPrice in New York: $3.73Real exchange rate: $3.73/(Y13/6.7) = $3.73/($1.97) = 1.89

People use this to argue that Yuan is “overvalued.”Anything wrong with this argument?

* http://www.economist.com/node/16646178?story_id=16646178

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Real exchange rate of $ relative to major currencies (R)

Appreciation

Depreciation

80

90

100

110

120

130

1975 1980 1985 1990 1995 2000 2005 2010

Do

llar

bu

bb

le w

ith

hig

h U

S i

nte

rest

ra

tes

Re

al

exc

ha

ng

e r

ate

ag

ain

st

bro

ad

co

un

try

gro

up

Inte

rne

t b

ub

ble

Flig

ht

to s

afe

ty

We saw last time that changes in the domestic S-I balance led to changes in NX (the trade balance).

We need next to understand the macroeconomic mechanism by which this occurs.

We will see that this operates through changes in the real exchange rate, which leads to changes in the relative prices of foreign and domestic goods.

Now to the Macroeconomic Equilibrium

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FINANCIAL COUNTERPART of S-I balance

NX = Spriv + Sgov – I = Sn – I

Net domestic saving = net foreign investment= lending abroad = ΔNFA= financial account deficit that corresponds to the current account surplus

The important condition is:

NX(R) = Spriv + Sg – I(rw)

Note on why S does not depend upon r (but unimportant for our analysis)

The only new relationship is NX(R):– Real deprecation (R ↓) lowers the price of exports in

foreign markets and raises import P in domestic markets.– This raises exports and lowers imports; raising NX.– Hence NX’(R) < 0

Putting this with the S-I curves, we can see how real exchange rate is determined.

32

Net exports and the real exchange rate

Real exchange rate (R)

NX(R)

NX0

R*

NX*

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Savings-investment and the determination of the real exchange rate:

NX(R) = Sn-I(rw)

R

NX(R)

0

R*

NX*

Sn-I(rw)

E*

Have two behavioral relationships: (1) NX and (2) net savings.

R and NX are determined as the equilibrium of

these two functions.

S-I, NX

34

Why does fiscal tightening lead to a lower trade deficit?

35

Fiscal policy:G ↓ →net S ↑ → R ↓ →NX ↑

R

NX(R)

S-I, NX0NX*

(S-I(rw))*

E**

(S-I(rw))**

NX**

E*

Fiscal tightening

Impact of protectionism

37

Protectionism

R

NX(R)

S-I, NX0NX*=NX**

(S-I(rw))

R*

R**

NX(R)’

Macroeconomics and political upheaval

39

Political crisis and a domestic risk premium

Question for class:

• Assume that there is a political crisis• Investors now require a risk premium for investing there (relative to the rest of the world)• What happens?• Domestic interest rate rises above world rate by risk premium (δ).• This is similar to rise in world interest rate.• Investment falls and the trade account heads toward deficit.• In a Keynesian world, the investment effect dominates and the country heads into recession.

Risk premiums on European debt

Source: Federal Reserve, Monetary Policy Report, July 2010.

Interest rate relevant for investment = Real interest rate with risk premium = Nominal risk-free rate – inflation + risk premium= i – π + δ

[Interest rate relative to German debt]

41

Shock III: A Greek Tragedy

S, I

Real interest rate (r)

Id (rd)

I*

rW

S = Sp + (T-G)

rd = rW

+ risk premium

I**

NX**

NX*

42

The world economy before the crisis

The world is a closed economy.Look at the global S-I balance using Bernanke’s

theory.

S, I

Real interest rate (r)

Id (r)

I*

r*

Sn = Spriv + (T-G)

Here are the basic data (pre-crisis)

-.06

-.05

-.04

-.03

-.02

-.01

.00

.01

2

4

6

8

10

12

14

16

80 82 84 86 88 90 92 94 96 98 00 02 04

Net exports/ GDP10-year T-bond rate

T-bond rate (----> )

NX/ GDP ( <---- )

Bernanke’s surprising theory of why the US deficit is so high

“I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today.” (Bernanke, 2005)

45

Global savings glut: Global effect

S, I

Real interest rate (r)

Id (r)

I*

r*

Sworld **Sworld *

r**

I**

46

From Greek tragedy to global tragedy

Suppose that the world is in an equilibrium with low real interest rates and zero inflation.

Then there is a big shock to investment, and the equilibrium real interest rate is very negative.

Outcome: liquidity trap and the Great Recession (in the Keynesian world we will examine next week).