ECO121-Macroeconomics Chapter

32
A
Macroeconomic
Theory
of the Open Economy
Lecturer : Mr. Nguyễn Quốc Quân
Email : quannq6@fe.edu.vn;
Phone : 0934940205
FPT Education- FPT University Danang Campus
In this chapter,
look for the answers to these questions:
• In an open economy, what determines the real
interest rate?
• How are the markets for loanable funds and
foreign-currency exchange connected?
• How do government budget deficits affect the
exchange rate and trade balance?
• How do other policies or events affect the
interest rate, exchange rate, and trade balance?

2
 Introduction
• The previous chapter explained the basic
concepts: net exports (NX), net capital
outflow (NCO), and exchange rates.
• This chapter ties these concepts together
into a theory of the open economy.
Use this theory to see how govt policies and
various events affect the trade balance,
exchange rate, and capital flows.

3
 I. The Market for Loanable Funds
An identity from the preceding chapter:

S = I + NCO
Saving Net capital
Domestic
investment outflow

 Supply of loanable funds = Saving.

 A dollar of saving can be used to finance
 the purchase of domestic capital
 the purchase of a foreign asset
 Demand for loanable funds = I + NCO
4
 The Market for Loanable Funds

• Recall:
–S depends positively on
the real interest rate, r.
–I depends negatively on r.
• What about NCO?
A MACROECONOMIC THEORY OF THE OPEN
ECONOMY
5
 How NCO Depends on the Real Interest Rate
The real interest rate ( r )
is the real return on
domestic assets. Net capital outflow
r
A fall in r makes domestic assets
less attractive
relative to foreign assets. r1
– People in the U.S. purchase
more foreign assets. r2
– People abroad purchase fewer
U.S. assets. NCO
– NCO rises.
NCO
NCO1 NCO2

6
A MACROECONOMIC THEORY OF THE OPEN ECONOMY
 The Loanable Funds Market Diagram
r adjusts to balance supply
r Loanable funds and demand in the LF market.

Both I and NCO depend

S = saving
negatively on r,
so the D curve is downward-
sloping.

r1

D = I + NCO

LF
ACTIVE LEARNING 1
Budget deficits and capital flows

• Suppose the government runs a budget deficit

(previously, the budget was balanced).
• Use the appropriate diagrams to determine
the effects on the real interest rate and
net capital outflow.

8
ACTIVE LEARNING 1 Answers
The higher r makes U.S. bonds more attractive relative
to foreign bonds, reduces NCO.
A budget deficit reduces saving and the supply of LF,
causing r to rise.

Loanable funds Net capital outflow

r r
S2
S1

r2 r2
r1 r1

D1 NCO1
LF NCO
9
 II. The Market for Foreign-Currency Exchange
• Another identity from the preceding chapter:

Net capital
NCO = NX Net exports
outflow

 In the market for foreign-currency exchange,

 NX is the demand for dollars:
Foreigners need dollars to buy U.S. net exports.
 NCO is the supply of dollars:
U.S. residents sell dollars to obtain the foreign
currency they need to buy foreign assets.
 The Market for Foreign-Currency Exchange
• Recall:
The U.S. real exchange rate (E) measures
the quantity of foreign goods & services
that trade for one unit of U.S. goods &
services.
–E is the real value of a dollar in the
market for foreign-currency
exchange.
A MACROECONOMIC THEORY OF THE OPEN ECONOMY
 The Market for Foreign-Currency Exchange
An increase in E makes U.S.
goods more expensive to
foreigners, reduces foreign Supply = NCO
E
demand for U.S. goods – and
U.S. dollars.
An increase in E
has no effect on saving or E1
investment, so it does not
affect NCO or the supply of
Demand = NX
dollars.
E adjusts to balance supply and Dollars
demand for dollars in the market
for foreign- currency exchange.
 FYI: Disentangling Supply and Demand
When a U.S. resident buys imported goods, does the
transaction affect supply or demand in the foreign exchange
market? Two views:
1. The supply of dollars increases.
The person needs to sell her dollars to obtain the foreign
currency she needs to buy the imports.
2. The demand for dollars decreases.
The increase in imports reduces NX, which we think of as the
demand for dollars. (So, NX is really the net demand for
dollars.)
Both views are equivalent. For our purposes,
it’s more convenient to use the second.
13
 FYI: Disentangling Supply and Demand
When a foreigner buys a U.S. asset, does the transaction affect
supply or demand in the foreign exchange market? Two
views:
1. The demand for dollars increases.
The foreigner needs dollars in order to purchase the U.S.
asset.
2. The supply of dollars falls.
The transaction reduces NCO, which we think of
as the supply of dollars.
(So, NCO is really the net supply of dollars.)
Again, both views are equivalent. We will use the second.

14
ACTIVE LEARNING 2
The budget deficit, exchange rate, and NX

• Initially, the government budget is balanced

and trade is balanced (NX = 0).
• Suppose the government runs a budget
deficit. As we saw earlier, r rises and NCO
falls.
• How does the budget deficit affect the U.S.
real exchange rate? The balance of trade?

15
ACTIVE LEARNING 2
Answers Market for foreign-
currency exchange
The budget deficit
reduces NCO and the S2 = NCO2
supply of dollars. E S1 = NCO1
The real exchange
rate appreciates, E2
reducing net exports. E1
Since NX = 0 initially,
the budget deficit D = NX
causes a trade deficit
(NX < 0).
Dollars
16
The “Twin Deficits” Net exports and the budget deficit
often move in opposite directions.
5%
4% U.S. federal
3% budget deficit
Percent of GDP

2%
1%
0%
-1%
-2%
-3% U.S. net exports
-4%
-5%

1995-2000
1991-95
1986-90
1981-85
1966-70

1971-75

1976-80

2001-05
1961-65
 SUMMARY: The Effects of a Budget Deficit

• National saving (S) falls

• The real interest rate ( r) rises
• Domestic investment (I) and net capital outflow
(NCO) both fall
• The real exchange rate ( E ) appreciates
• Net exports (NX) fall (or, the trade deficit
increases)

18

A MACROECONOMIC THEORY OF THE OPEN ECONOMY

 SUMMARY: The Effects of a Budget Deficit
• One other effect:
As foreigners acquire more domestic assets,
the country’s debt to the rest of the world increases.
• Due to many years of budget and trade deficits,
the U.S. is now the “world’s largest debtor nation.”

International investment position of the U.S.

31 December 2007
Value of U.S.-owned foreign assets $17.6 trillion
Value of foreign-owned U.S. assets $20.1 trillion
U.S.’ net debt to the rest of the world $2.5 trillion
19
A MACROECONOMIC THEORY OF THE OPEN ECONOMY
The Connection r
Between r2
Interest Rates
and Exchange Rates r1

Anything
Keepthat
in mind: NCO
increases
The LF marketr (not shown) NCO
determines NCO2 NCO1
will reduce NCOr.
Thissupply
value of E
and the of r S2 S1 = NCO1
then determines
dollars NCO
in the foreign
(shown in upper graph). E2
exchange market.
This value of NCO then E1
Result:
determines supply of D = NX
The real exchange
dollars in foreign exchange dollars
rate appreciates.
market (in lower graph). NCO2 NCO1
20
ACTIVE LEARNING 3
Investment incentives

• Suppose the government provides new

tax incentives to encourage investment.
• Use the appropriate diagrams to determine
how this policy would affect:
– the real interest rate
– net capital outflow
– the real exchange rate
– net exports

21
ACTIVE LEARNING 3
Answers
Investment – and the demand for LF – increase at each
value of r.
r rises, causing NCO to fall
Loanable funds Net capital outflow
r r
S1

r2 r2
r1 r1
D2
D1 NCO
LF NCO
NCO2 NCO1 22
ACTIVE LEARNING 3
Answers
Market for foreign-
currency exchange
The fall in NCO
reduces the S2 = NCO2
supply of dollars E S1 = NCO1
in the foreign
exchange market. E2
The real exchange
E1
rate appreciates,
reducing net exports.
D = NX

Dollars
23
 Budget Deficit vs. Investment Incentives
• A tax incentive for investment has similar effects as
a budget deficit:
– r rises, NCO falls
– E rises, NX falls
• But one important difference:
– Investment tax incentive increases investment, which
increases productivity growth and living standards in the
long run.
– Budget deficit reduces investment, which reduces
productivity growth and living standards.
24
 Trade Policy
• Trade policy:
a govt policy that directly influences the quantity of g&s that
a country imports or exports
• Examples:
– Tariff – a tax on imports
– Import quota – a limit on the quantity of imports
– “Voluntary export restrictions” – the govt
pressures another country to restrict its exports;
essentially the same as an import quota
 Trade Policy
• Common reasons for policies to restrict imports:
– Save jobs in a domestic industry that has difficulty
competing with imports
– Reduce the trade deficit
• Do such trade policies accomplish these goals?
• Let’s use our model to analyze the effects of
an import quota on cars from Japan
designed to save jobs in the U.S. auto industry.

A MACROECONOMIC THEORY OF THE OPEN 26

ECONOMY
 Analysis of a Quota on Cars from Japan
An import quota does not affect saving or investment,
so it does not affect NCO. (Recall: NCO = S – I.)

Loanable funds Net capital outflow

r r
S

r1 r1

D NCO
LF
A MACROECONOMIC THEORY OF THE OPEN 27
NCO
ECONOMY
 Analysis of a Quota on Cars from Japan
Since NCO unchanged, Market for foreign-
S curve does not shift. currency exchange
The D curve shifts: E S = NCO
At each E,
imports of cars fall, E2
so net exports rise,
D shifts to the right. E1
At E1, there is excess D2
demand in the foreign
D1
exchange market.
E rises to restore eq’m. Dollars
28

A MACROECONOMIC THEORY OF THE OPEN ECONOMY

 Analysis of a Quota on Cars from Japan
What happens to NX? Nothing!
• If E could remain at E1, NX would rise, and the
quantity of dollars demanded would rise.
• But the import quota does not affect NCO,
so the quantity of dollars supplied is fixed.
• Since NX must equal NCO, E must rise enough to
keep NX at its original level.
• Hence, the policy of restricting imports
does not reduce the trade deficit.
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A MACROECONOMIC THEORY OF THE OPEN ECONOMY

 Analysis of a Quota on Cars from Japan
Does the policy save jobs?
The quota reduces imports of Japanese autos.
– U.S. consumers buy more U.S. autos.
– U.S. automakers hire more workers to produce these
extra cars.
– So the policy saves jobs in the U.S. auto industry.
But E rises, reducing foreign demand for U.S. exports.
– Export industries contract, exporting firms lay off
workers.
The import quota saves jobs in the auto industry
but destroys jobs in U.S. export industries!!
30
 CASE STUDY: Capital Flows from China
• In recent years, China has accumulated U.S. assets to
reduce its exchange rate and boost its exports.
• Results in U.S.:
– Appreciation of $ relative to Chinese renminbi
– Higher U.S. imports from China
– Larger U.S. trade deficit
• Some U.S. politicians want China to stop,
argue for restricting trade with China to protect
some U.S. industries.
• Yet, U.S. consumers benefit, and the net effect of China’s
currency intervention is probably small.
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A MACROECONOMIC THEORY OF THE OPEN ECONOMY

 Political Instability and Capital Flight
• 1994: Political instability in Mexico made
world financial markets nervous.
– People worried about the safety of Mexican assets
they owned.
– People sold many of these assets, pulled their
capital out of Mexico.
• Capital flight: a large and sudden reduction in
the demand for assets located in a country
• We analyze this using our model, but from the
prospective of Mexico, not the U.S.
A MACROECONOMIC THEORY OF THE OPEN 32
ECONOMY
 Capital Flight from Mexico
Demand for LF = I + NCO.
The increase in NCO increases demand for LF.
The equilibrium values of r and NCO both increase.
As foreign investors sell their assets and pull out their
capital, NCO increases
Loanable funds at each valueNetof capital
r. outflow
r r
S1

r2 r2
r1 r1
D2 NCO2
D1 NCO1
LF NCO
A MACROECONOMIC THEORY OF THE OPEN 33
ECONOMY
 Capital Flight from Mexico
Market for foreign-
The increase in NCO currency exchange
causes an increase in
E S1 = NCO1
the supply of pesos in
the foreign exchange S2 = NCO2
market.
The real exchange rate E1
value of the peso falls.
E2
D1

Pesos
A MACROECONOMIC THEORY OF THE OPEN 34
ECONOMY
 US Dollars per currency unit .

0.10
0.15
0.20
0.25
0.30
0.35
10/23/1994

11/12/1994

12/2/1994

12/22/1994

1/11/1995

1/31/1995

2/20/1995

3/12/1995
Examples of Capital Flight: Mexico, 1994

4/1/1995
 US Dollars per currency unit.
1/1/1997 = 100

100
120

0
20
40
60
80
12/1/1996

2/24/1997

5/20/1997

8/13/1997

11/6/1997

1/30/1998
Examples of Capital Flight: S.E. Asia, 1997

4/25/1998
Thai Baht
Indonesia Rupiah
South Korea Won

7/19/1998
 US Dollars per currency unit .

0.00
0.04
0.08
0.12
0.16
0.20
5/5/1998

6/14/1998

7/24/1998

9/2/1998

10/12/1998

11/21/1998
Examples of Capital Flight: Russia, 1998

12/31/1998
 U.S. Dollars per currency unit .

0.0
0.2
0.4
0.6
0.8
1.0
1.2
7/1/2001

9/19/2001

12/8/2001

2/26/2002

5/17/2002

8/5/2002

10/24/2002
Examples of Capital Flight: Argentina, 2002

1/12/2003
 CASE STUDY: The Falling Dollar
U.S. trade-weighted nominal exchange
90 rate index, March 1973 = 100

From 10/2005
85
to 6/2008,
the dollar
80
depreciated
17.3%
75

70

65
2005 2006 2007 2008 39
 CASE STUDY: The Falling Dollar
Two likely causes:
• Subprime mortgage crisis
– Reduced confidence in U.S. mortgage-backed
securities
– Increased NCO
• U.S. interest rate cuts
– From 7/2006 to 7/2008, Federal Funds target rate
reduced from 5.25% to 2.00% to stimulate the
sluggish U.S. economy.
– Increased NCO
40

A MACROECONOMIC THEORY OF THE OPEN ECONOMY

 CONCLUSION
• The U.S. economy is becoming increasingly
open:
– Trade in g&s is rising relative to GDP.
– Increasingly, people hold international assets in
their portfolios and firms finance investment with
foreign capital.

41
 CONCLUSION
• Yet, we should be careful not to blame our
problems on the international economy.
– Our trade deficit is not caused by
other countries’ “unfair” trade practices,
but by our own low saving.
– Stagnant living standards are not caused by imports, but
by low productivity growth.
• When politicians and commentators
discuss international trade and finance,
the lessons of this and the preceding chapter
can help sparate myth from reality. 42
 CHAPTER SUMMARY

• In an open economy, the real interest rate adjusts to

balance the supply of loanable funds (saving) with
the demand for loanable funds (domestic
investment and net capital outflow).
• In the market for foreign-currency exchange,
the real exchange rate adjusts to balance the supply
of dollars (net capital outflow) with the demand for
dollars (net exports).
• Net capital outflow (NCO) is the variable that
connects these markets. 43
 CHAPTER SUMMARY

• A budget deficit reduces national saving, drives

up interest rates, reduces net capital outflow,
reduces the supply of dollars in the foreign
exchange market, appreciates the exchange rate,
and reduces net exports.
• A policy that restricts imports does not affect net
capital outflow, so it cannot affect net exports or
improve a country’s trade deficit. Instead, it
drives up the exchange rate and reduces exports
as well as imports.
44
 CHAPTER SUMMARY

• Political instability may cause capital flight,

as nervous investors sell assets and pull
their capital out of the country. As a result,
interest rates rise and the country’s
exchange rate falls. This occurred in Mexico
in 1994 and in other countries more
recently.

45