Macroeconomics & The global economy

Ace Institute of Management

Chapter 5: The open economy

InstructorSandeep Basnyat

Sandeep_basnyat@yahoo.com9841 892281

Open Economy: • Open to foreigners• Contrary to Closed Economy: Export and Import some of its

goods and services to other countries including capital mobility

Y = Cd + Id + Gd + EX

Consumption of Domestic Goods and

Services

Investment in Domestic

Goods and Services

Govt. Purchase of

Domestic Goods and

Services

Export of Domestic

Goods and Services

Domestic Spending on Domestic Goods and

Services

Foreign Spending on

Domestic Goods and

Services

C = Cd +Cf

or, Cd = C - Cf

We know that, Domestic Spending on all Goods and Services = Domestic Spending on Domestic Goods and Services + Domestic Spending on Foreign Goods and Services

C = Total ConsumptionCd = Consumption of Domestic goods & servicesCf = Consumption of Foreign goods & services

I = Id +If

or, Id = I - If

I = Total InvestmentId = Investment in Domestic goods & servicesIf = Investment in Foreign goods & services

G = Gd +Gf

or, Gd = G - Gf

G = Total Govt. PurchaseGd = Govt. Purchse. of Domestic goods & servicesGf = Govt. Purchse. of Foreign goods & services

Y = (C - Cf) + (I - If) + (G - Gf) + EX

Y = C + I + G + EX–(Cf+If+Gf)Expenditure on ImportsY = C + I + G + EX–IM

Y = C + I + G + NX Net Exports or Trade BalanceNX= Y – (C + I + G)

Net Exports = Output – Domestic Spending

If Output > Domestic Spending : NX Positive: Export moreIf Output < Domestic Spending : NX Negative: Import more

Domestic spending

neednot equal the

Output

Y = C + I + G + NX

Y–C – G= I+ NX

S = I+ NX

S – I = NX

Net Exports or Trade Balance

Net Capital Outflow or Net Foreign Investment

Net Capital Outflow = Trade BalanceIn Equilibrium,

• If, Domestic S > Domestic I, NCO is +ve ; Excess ‘S’ will be loaned out to foreigners and economy experiences Capital Outflow.• If, Domestic S < Domestic I, NCO is -

ve ; Deficit financing is done by borrowing from abroad and economy experiences Capital Inflow.•Net Capital Outflow = Amount that

Domestic residents are lending abroad – Amount that foreigners are lending to us

S – I = NX Net Capital Outflow = Trade Balance

In Equilibrium,

• Condition of Trade Surplus: • If S – I is positive, NX is positive, implies Trade Surplus•Net Lender in International Financial Market

• Condition of Trade Deficit• If S – I is negative, NX is negative, implies Trade Deficit•Net Borrower from International Financial Market

• Condition of Balance Trade• If S – I is exactly equals to NX

The national income account identity shows that the international flow of funds to finance capital accumulation and the flow of goods

and services are two sides of the same coin.

An Important Macroeconomic Model

Relating toSaving and Investment and

Trade Balance

Assumptions:

• Small Economy: Economy that is a small part of the world economy and can not affect the world interest rates.• Perfect Capital Mobility: Country has full access to world

financial markets.• Domestic Interest rate (r) = World Interest Rate (r*) due to

perfect capital mobility

Determination of Interest Rates:Domestic : Intersection of Domestic Savings and InvestmentWorld: Intersection of World Savings and Investment

– production function

– consumption function

– investment function

– exogenous policy variables

Y Y F K L ( , )

C C Y T ( )

I I r ( )

G G T T ,

More Assumptions:

National saving: The supply of loanable funds

r

S, I

( )S Y C Y T G

S

More Assumptions:

Investment: The demand for loanable funds

r *

but the exogenous world interest rate…

…determines the country’s level of investment.

I (r* )

r

S, I

I (r )

More Assumptions:

If the economy were closed…r

S, I

I (r )

S

rc

cI

S

r

( )

…the interest rate would adjust to equate investment and saving:

…the interest rate would adjust to equate investment and saving:

Explanations:

But in a small open economy…r

S, I

I (r )

S

rc

r*

I 1

the exogenous world interest rate determines investment…

the exogenous world interest rate determines investment…

…and the difference between saving and investment determines net capital outflow and net exports

…and the difference between saving and investment determines net capital outflow and net exports

NX

Explanations:

Case of Trade Surplus (S >I)

r

S, I

I (r )

S

rc

Explanations:

Trade Deficit (S < I)

r*

I 1

Or, Case of Trade Deficit

How do government policies affect Trade Balance?

Three Cases:

Case 1: Starting from Trade Balance, What happens if the Home Government uses expansionary fiscal polices such as increase in ‘G’ or reduce ‘T’? (Fiscal policy at home)

Case 2: Starting from Trade Balance, What happens if the Foreign Government uses expansionary fiscal polices such as increase in ‘G’?(Fiscal policy abroad)

Case 3: Starting from Trade Balance, What happens if the Investment increases in the home country?(An increase in investment demand)

Case 1: Starting from Trade Balance, What happens if the Home Government uses expansionary fiscal polices such as increase in ‘G’ or reduce ‘T’?

How Policies Influence the Trade Balance?

As we know,

i) S = Y – C – G; When ‘G’ increases, ‘S’ decreases.

ii) As ‘T’ decreases due to tax cut, disposable income Y – T increase;• Stimulate consumption and ‘C’ increases • Which lowers ‘S’

Fiscal policy at homer

S, I

I (r )

1SAn increase in G or decrease in T reduces saving.

An increase in G or decrease in T reduces saving.

1*r

2S

- NX

I 1

S < IS < I

Country runs trade deficitCountry runs trade deficit

Starting from Trade Balance, a change in fiscal policy that reduces national savings causes Trade Deficit

Case 2: Starting from Trade Balance, What happens if the Foreign Government uses expansionary fiscal polices such as increase in ‘G’?

How Policies Influence the Trade Balance?

Considering the foreign economy is large enough

i) Increase in “G” by foreign government reduces world “S” and world interest rate “r*” rises.

ii) Rise in ‘r*’ increases costs of borrowing and reduces domestic “I”.

iii) Since domestic “S” has not change, S>I and some of the savings flow abroad as capital outflow.

iv) Again, as NX = S – I; NX increases as “I” decreases that leads to Trade Surplus.

Fiscal policy abroadr

S, I

I (r )

1SExpansionary fiscal policy abroad raises the world interest rate.

1*r

NX2

2*r

2( )*I r 1( )*I r

S > IS > I

Country runs trade surplusCountry runs trade surplus

Starting from Trade Balance, an increase in the world interest rate due to fiscal expansion abroad causes Trade Surplus

Case 3: Starting from Trade Balance, What happens if the Investment increases in the home country in existing r?

How Policies Influence the Trade Balance?

i) Increase in “I” but no change in “r*”ii) Since “S” has not change, S<I and some of the investment

has to be financed by borrowing from abroad as capital inflow.

iii) Again, as NX = S – I; NX decreases as “I” increases that leads to Trade Deficit.

An increase in investment demand

r

S, I

I (r )1

- NX*r

I 1 I 2

S

I (r )2

S < IS < I

Country runs trade deficitCountry runs trade deficit

Starting from Trade Balance, an outward shift in the investment schedule causes Trade Deficit

23

The exchange rate between two countries is the price at which residents of those countries trade with each other.

• Nominal and Real

The nominal exchange rate

e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Nepali Rs. 73 per US Dollar)

e

Dollar Value of Transactions

D$

Ae0

S$

$

•Demand and Supply for the currency determines the exchange rate.• Important factor: trade and Investment requirements

D$ shifts rightward and increases the nominal exchange rate, e. This is known as appreciation of the dollar.Be1

e

Dollar Value of Transactions

D$

Ae0

S$

$

Suppose there is an increase in the demand for U.S. Dollars in Nepal (for importing goods and services or going abroad). How will this affect the nominal exchange rate for US dollar in Nepal?

Events which decrease the demand for the dollar, and thus decrease e, would be a depreciation of the dollar.

D$

Understanding Real Interest Rate

• A Japanese businessman thinks that Japanese cars made in the US are far better than those made in Japan.

• The car model he likes in Japan costs 2400,000 Japanese Yen. The existing spot (nominal) exchange rate is 120 Yen/dollar.

Understanding Real Interest Rate

• So, he exchanges 2400,000 Japanese Yen for $20,000 and Travels to US to buy the same car.

• For his surprise, the same car in US costs only $10,000.

• What are his impressions about the US and Japanese currencies?

Understanding Real Interest Rate

Impression:1. Overvaluation of Japanese

currency:He can buy more cars (2 cars) in US than Japan with same amount of money. The Japanese Yen is overvalued

2. Real exchange rate is different from nominal exchange rate:1 American car = 0.5 Japanese Car (as US car costs half the price of the car in Japan).

The real exchange rate = real exchange rate,

the relative price of domestic goods in terms of foreign goods (e.g. How many Nepali KFC baskets can you buy with the amount you pay for 1 U.S. KFC basket?)

the lowercase

Greek letter epsilon

ε

Relationship between ‘e’ and ‘e ’

Real Exchange Rate

=Nominal Exchange Rate at Home x Price of Domes. Goods

Price of Foreign Goods

Real Exchange Rate

=Nominal Exchange Rate

XRelative Price of Goods

e = e X (P / P*)

P = Price of Domestic GoodsP* = Price of Foreign Goods

The real exchange rate with KFCCosts of KFC basket in Nepal = Rs. 900Costs of same KFC basket in US = $10If the nominal exchange rate is Rs. 73/dollar,1) What is the real exchange rate?2) Is Nepalese currency overvalued or undervalued

compared to US currency?

The real exchange rate with KFCCosts of KFC basket in Nepal = Rs. 900Costs of same KFC basket in US = $10If the nominal exchange rate is Rs. 73/dollar,1) What is the real exchange rate? – 1.232) Is Nepalese currency overvalued or undervalued

compared to US currency? - Overvalued

Relationship between NX and ε ?

ε Nepalese goods become more expensive relative to US goods

EX, IM

NX

U.S. net exports and the real exchange rate, 1973-2006

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

1973 1977 1981 1985 1989 1993 1997 2001 2005

NX

(% o

f GD

P)

0

20

40

60

80

100

120

140

Inde

x (M

arch

197

3 =

100)

Trade-weighted real exchange rate index

Net exports(left scale)

The net exports function• The net exports function reflects this inverse

relationship between NX and ε :

NX = NX(ε )

NXNX(ε

)

ε 1

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,

( ) ( )*NX ε S I r

How ε is determinedNeither S nor I depend on ε, so the net capital outflow curve is vertical.

Neither S nor I depend on ε, so the net capital outflow curve is vertical.

ε

NX

NX(ε

)

1 ( *)S I r

ε adjusts to equate NX with net capital outflow, S - I.

ε adjusts to equate NX with net capital outflow, S - I.

ε 1

NX 1

Next, four applications:

Impact on Real Exchange Rate due to:

1. Expansionary Fiscal policy at home

2. Expansionary Fiscal policy abroad

3. Domestic increase in investment demand

4. Trade policy to restrict imports

1. Fiscal policy at home

A fiscal expansion reduces national saving, net capital outflow, and the supply of NPR against dollars in the foreign exchange market…

A fiscal expansion reduces national saving, net capital outflow, and the supply of NPR against dollars in the foreign exchange market…

…causing the real exchange rate to rise and NX to fall.

…causing the real exchange rate to rise and NX to fall.

ε

NX

NX(ε

)

1 ( *)S I r

ε 1

NX 1NX 2

2 ( *)S I r

ε 2

2. Fiscal policy abroadExpansionary Fiscal Policy abroad increases world interest rate r*, reduces investment in Nepal, increasing net capital outflow (S>I) and the supply of NPR against dollars in the foreign exchange market…

Expansionary Fiscal Policy abroad increases world interest rate r*, reduces investment in Nepal, increasing net capital outflow (S>I) and the supply of NPR against dollars in the foreign exchange market…

…causing the real exchange rate to fall and NX to rise.

…causing the real exchange rate to fall and NX to rise.

ε

NX

NX(ε

)

1 1( *)S I r

NX 1

ε 1

21 ( )*S I r

ε 2

NX 2

3. Increase in investment demand at home

An increase in investment in Nepal reduces net capital outflow (S<I) and the supply of NPR against dollars in the foreign exchange market…

An increase in investment in Nepal reduces net capital outflow (S<I) and the supply of NPR against dollars in the foreign exchange market…

ε

NX

NX(ε

)…causing the real exchange rate to rise and NX to fall.

…causing the real exchange rate to rise and NX to fall.

ε 1

1 1S I

NX 1

21S I

NX 2

ε 2

4. Trade policy to restrict imports

ε

NX

NX (ε )1

S I

NX1

ε 1

NX (ε )2

At any given value of ε, an import quota

IM NX (Note: Net Export = Export – Import)

At any given value of ε, an import quota

IM NX (Note: Net Export = Export – Import)

Trade policy doesn’t affect S or I , so capital flows and the supply of NPR against US Dollar remain fixed.

Trade policy doesn’t affect S or I , so capital flows and the supply of NPR against US Dollar remain fixed.

ε 2

Purchasing Power Parity (PPP)

Law of One Price:– A doctrine that states that goods must sell at the

same (currency-adjusted) price in all countries.– The nominal exchange rate adjusts to equalize the

cost of a basket of goods across countries.

Reasoning: – arbitrage, the law of one price

Purchasing Power Parity (PPP)

• PPP: e P = P*

Cost of a basket of domestic goods, in foreign currency.

Cost of a basket of domestic goods, in domestic currency.

Cost of a basket of foreign goods, in foreign currency.

Solve for e : e = P*/ P

PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels.

Does PPP hold in the real world?• No, for two reasons:

1. International arbitrage not possible.• nontraded goods• transportation costs

2. Different countries’ goods not perfect substitutes.

• Nonetheless, PPP is a useful theory:– It’s simple & intuitive– In the real world, nominal exchange rates

tend toward their PPP values over the long run.

Thank You