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OPEN ECONOMY

MACROECONOMICSChapter 28

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Foreign Trade and Economic Activity

Net Exports and Output in the Open Economy

Open Economy Macroeconomics- Study of how economies behave when the trade

and financial linkages among nations are considered.

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Exports

-g/s produced domestically and purchased by

foreigners

Posit ive net exports: Net foreign investments

Negative net expo rts: Foreign indebtedness isgrowing

Net Exports = exports of g/s imports of g/s

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Total Domestic Output = GDP Domestic expenditures + Net exports = C + I +G +X

Domestic expenditures

equal to consumption plus domestic investment plus

govt purchases.

Difference between GDP and Domestic expenditures:

1. Some part of domestic expenditures will be on goods

produced abroad.

2. Some part of domestic production will be sold abroad asexports

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Variables that Influence Net Exports

Consumers preferences for foreign and domestic goods

Prices of goods at home and abroad

Incomes of consumers at home and abroad

The exchange rates at which foreign currency trades fordomestic currency

Transportation costs

Govt policies

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Short Run Impact of Trade on GDP

Two new macroeconomic elements in international trade:1. Net exports

2. An open economy has two different multipliers for privateinvestments and govt domestic spending

Equilibrium output in an open economy occurs where total netdomestic product and foreign spending equals total domesticoutput

Elements of Imports:

Exogenous materials like prices andexchange rates

Domestic Income and output

Elements of Exports

Exogenous materials like prices andexchange rates

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Marginal Propensity to Import and the

Spending line

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The Open Economy Multiplier

=1

+

The effect of a sustained increase in governmentspending (or investment) on incomethat is, the

multiplieris smaller in an open economy than in a

closed economy. The reason: When government

spending (or investment) increases and income andconsumption rise, some of the extra consumption

spending that results is on foreign products and not on

domestically produced goods and services

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The Monetary Transmission Mechanism

in an Open Economy

Overvalued Currenc y: one whose value is high relative

to its long-run or sustainable level.

US dollar was overvalued in 1985

High mob i l ity o f f inancia l capi tal: when financial

investments can flow easily among countries and the

regulatory barriers to financial investments are low.

United States, Japan, countries of the European Union

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Fixed Exchange Rates

Interest rates of countries with fixed exchange rates and

high capital mobility must be very closely aligned.

Any divergence between two countries will attract speculators who

will sell one currency and buy the other until the interest rates are

equalized.

Fiscal policy is highly effective.

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Flexible Exchange Rates

Has a reinforcing effect on monetary policy

Monetary Easing

Monetary Tightening

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Monetary Easing

MonetaryEasing

Lowerinterestrates

Depreciationof the

currency

StimulatesExports anddiscourages

imports

Net exportsurplus

Increasedomestic

investment

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Monetary Easing

Net export expansion

0

500

1000

1500

2000

2500

3000

3500

4000

4500

1000 2000 3000 4000

C + I + G + X(e*)

C + I + G + X(e**)

Q* Q**

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Monetary Tightening

Monetarytightening

Highinterestrates

Appreciation of thecurrency

Increasein export

prices anddecreasein import

prices

Net exportdeficit

Recession

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SAVING AND INVESTMENT IN A

SMALL OPEN ECONOMYSmall open economy: an economy too small to affect theworld real interest rate

World real interest rate (rw): the real

interest rate in the international capitalmarket

Key assumption: Residents of thesmall open economy can borrow or lend

at the expected world real interest rate

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National saving and investment in a small open

economy

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A small open economy that lends abroad

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A small open economy that borrows

abroad

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Result: rwmay be such that Sd> Id, Sd= Id, orSd< Id

Ifrw= r1, then Sd> Id, so the excess of desiredsaving over desired investment is lentinternationally (net foreign lending is positive)and NX> 0

Ifrw= r2, then Sd= Id, so there is no net foreignlending and NX= 0

Ifrw= r3, then Sd< Id, so the excess of desiredinvestment over desired saving is financed by

borrowing internationally (net foreign lending isnegative) and NX< 0

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Saving and Investment in Large Open

EconomiesLarge open economy: an economy largeenough to affect the world real interest rate Suppose there are just two economies in the world

The home or domestic economy (saving S,investment I)

The foreign economy, representing the rest ofthe world (saving SFor, investment IFor)

The world real interest rate moves to equilibrate desired

international lending by one country with desired internationalborrowing by the other

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Equivalent statement: The equilibrium world real interest rate isdetermined such that a current account surplus in one country is

equal in magnitude to the current account deficit in the otherChanges in the equilibrium world real interest rate: Any factor that

increases desired international lending of a country relative todesired international borrowing causes the world real interest rateto fall

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ECONOMIC GROWTH IN THE OPEN

ECONOMY

Small open economies International trade

International finance

Other issues Trade policies

Intellectual property rights

Policies toward direct investment

Overall macroeconomic climate

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PROMOTING GROWTH IN THE

OPEN ECONOMY

Best-practice techniques in production processes

Low tariffs and other barriers to trade

Most successful open economies:

Europe: Netherlands, Luxembourg

Asia: Taiwan, Hong Kong

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Not only physical but also intangible capital

Development of intellectual property rights

Stable macroeconomic climate

-taxes are reasonable and predictable and thatinflation is low, so lenders need not worry about

inflation confiscating their investments.

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Low-Risk Country High-Risk Country

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INTERNATIONAL ECONOMIC ISSUES

Two of the central issues that have concerned nations in

recent years:

1. COMPETITIVENESS and PRODUCTIVITY

2. Birth of European Monetary Union

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The Deindustrialization of America

During 1980s and later surfaced in the 2000s the

appreciation of dollar produced severe hardships in many

US sectors exposed to international trade.

COMPETITIVENESSextent to which a nations goods

can compete in the marketplace

PRODUCTIVITY measured by the output per unit of

input

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Trends in Productivity

Importance of COMPETITION and OUTWARD

ORIENTATION

Theory of Comparative Advantage nations are not

inherently uncompetitive

HIGH PRODUCTIVITY and HIGH LIVING STANDARDS =

expose domestic industries to world markets and

encourage them to adopt the most advanced technologies

in the world

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The European Monetary Union

IDEAL EXCHANGE RATE SYSTEM allows high levelsof predictability of relative prices while stabilizing the

economy in the face of economic shocks

Fixed exchange rate system subject of intense

speculative attacks EU countries took the giant step of linking their economic

fortunes through European Monetary Union, which forged

a common currency, the Euro.

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Toward a Common Currency: The Euro This economic integration would not only foster economic

ties but also resolve the problem of unstable currencies that

plagued the earlier fixed-exchange-rate systems.

11 European countries joined the EMU in 1999, these

countries adopted the Euro as their unit of account and

medium of exchange.

European Central Bank conducts monetary policy for

countries in the accord and thereby determine the interest

rates for the Euro.

PRIMARY OBJECTIVE of ECB: To pursue price stability

Price Stability increase in Euroland consumer prices of

below 2% per year over the medium term

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Costs and Benefits of Monetary UnionBENEFITS

Exchange rate volatility will be reduced to zero

More efficient allocation of capital across countries

Political integration and stability of Western Europe

COSTS

Individual countries will lose the use of both monetarypolicy and exchange rates as tools for macroeconomicadjustments

OPTIMAL CURRENCY AREA is one whose regionhave high labor mobility or have common andsynchronous aggregate supply or demand shocks

The creation of the Euro has removed the intra-European

exchange rate movements

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FINAL ASSESSMENT

Robust economic performance- It is the period which these countries avoided deep

depression and the cancer of hyperinflation

The emerging monetary system

- Major economic regions with flexible exchange rate rates,while smaller countries either float or have hard fixed

exchange rates

The reemergence of free markets

- Market-oriented countries of the West prospered whilecentrally planned command economies collapsed