Ch19 - Macroecon Theory of Open Economy

N.
GREGORY MANKIW NINTH EDITION
PRINCIPLES OF
MACRO
ECONOMICS
CHAPTER
A Macroeconomic Theory
of the Open Economy
Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 1
IN THIS CHAPTER
• In an open economy, what determines the
real interest rate? The real exchange 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?
license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
2
Theory of the Open Economy – 1
• Assumptions:
– Economy’s GDP is given
• Real GDP is determined by factors of
production and available technology
– Economy’s price level is given
• Price level adjusts to bring the supply
and demand for money into balance
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a 3
Theory of the Open Economy – 2
• The model
– Highlights the forces that determine the
economy’s trade balance and exchange
rate
– Looking simultaneously at two related
markets:
• The market for loanable funds
• The market for foreign-currency
exchange
The Market for Loanable Funds – 1
• In an open economy, S = I + NCO
Saving = Domestic investment + Net
capital outflow
• Market for loanable funds:
– Supply of loanable funds: from national
saving (S)
– Demand for loanable funds: from
domestic investment (I) and net capital
outflow (NCO)
The Market for Loanable Funds – 2
• Net outflow of capita when NCO > 0
– Net purchase of capital overseas adds to
the demand for domestically generated
loanable funds
• Net inflow of capital when NCO < 0
– Capital resources coming from abroad
reduce the demand for domestically
generated loanable funds
How NCO depends on the real interest rate
The real interest rate, r, is Net capital outflow
the real return on domestic
r
assets.
A fall in r makes domestic
assets less attractive r1
relative to foreign assets.
r2
– People in the U.S.
purchase more foreign
NCO
assets.
– People abroad purchase NCO1 NCO2 NCO
fewer U.S. assets.
– NCO rises.
7
The market for loanable funds diagram
Loanable funds • Both I and NCO

depend negatively
r
on r, so the D curve
S = saving is downward-
sloping.
r1
• r adjusts to balance
D = I + NCO supply and demand
in the LF market.
LF
8
EXAMPLE 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.
9
Foreign-Currency Exchange Market – 1
• The market for foreign-currency exchange
– Trade U.S. dollars in exchange for foreign
currencies
– Identity: NCO = NX
– 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.
Foreign-Currency Exchange Market – 2
• 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.
– E balances the supply and demand in the
market for foreign-currency exchange
The market for foreign-currency exchange
• An increase in E makes
U.S. goods more E Supply =
expensive to foreigners, NCO
and reduces the quantity
of dollars demanded to
E1
buy those goods.
• An increase in E has no
effect on S or I, so it does Demand = NX
not affect NCO or the
supply of dollars. Dollars
• E adjusts to balance supply and demand for dollars
in the market for foreign- currency exchange.
12
EXAMPLE 2A: Supply or demand?
Shemar, a U.S. resident and business owner, buys cars
made in Germany.
• How is this transaction affecting supply or demand in
the foreign exchange market?
13
EXAMPLE 2B: Demand or supply?
Alexandra, a French business owner, buys wine
made in U.S. for her French restaurants.
• How is this transaction affecting supply or demand
in the foreign exchange market?
14
Active Learning 1: Budget deficits, again
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
The “Twin Deficits” 1960-2019
8.00%
Net exports and the budget deficit often move in
opposite directions.
6.00%
U.S. federal budget deficit
4.00%
Percent of GDP
2.00%
0.00%
U.S. net exports
-2.00%
-4.00%
-6.00%
16
The Effects of a Budget Deficit – 1
• The effects of a budget deficit:
– National saving falls
– The real interest rate rises
– Domestic investment and net capital
outflow both fall
– The real exchange rate appreciates (E
increases)
– Net exports fall (or, the trade deficit
increases)
The Effects of a Budget Deficit – 2
• 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.
30 September 2019
Value of U.S.-owned foreign assets $ 28.01 trillion
Value of foreign-owned U.S. assets $ 38.56 trillion
U.S.’ net debt to the rest of the world $ 10.56 trillion
The connection between r and E
Anything that increases r r
r2
will reduce NCO NCO
and the supply of dollars in the r1
foreign exchange market.
Result: The real exchange rate NCO2 NCO1
appreciates. NCO
Keep in mind: The LF market
(not shown) determines r. E S2 S1 = NCO1
This r determines NCO (shown
E2
in upper graph).
E1
This NCO determines supply
of dollars in foreign exchange D = NX
NCO2 NCO1
market (in lower graph). dollars
19
Active Learning 2: Investment incentives
Suppose the government provides new tax
incentives to encourage investment.
• Use the appropriate diagrams to determine
how this policy would affect:
A. the real interest rate, r
B. net capital outflow, NCO
C. the real exchange rate, E
D. net exports, NX
20
Effects of 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.
ASK THE EXPERTS
Deficits
“If the United States reduced its fiscal deficit,
then its trade deficit would also shrink.”
Source: IGM Economic Experts Panel, June 21, 2017.
22
Trade Policy
• Trade policy:
– Government policy that directly influences the
quantity of goods and services a country imports
or exports
– Tariff: a tax on imported goods
– Import quota: limit on the quantity of imports
• Some arguments for restricting trade:
– Save jobs in domestic industry
– Reduce the trade deficit
EXAMPLE 3: Protecting domestic auto makers
Suppose the government uses import quotas on
cars imported from Japan, in order to protect jobs
in the domestic auto industry.
• Use the appropriate diagrams to determine how
this policy would affect:
A. the real interest rate, r
B. net capital outflow, NCO
C. the real exchange rate, E
D. net exports, NX
E. Does the policy saves U.S. jobs?
24
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:
– Large and sudden reduction in the
demand for assets located in a country
Capital flight from Mexico – 1
Demand
As foreignforinvestors
LF = I + sell
NCO. their
Theassets
increase
and pull
in NCO
out their
increases
capital,
NCO increases
demand for LF. at each value of r.
The equilibrium values of r and NCO both increase.
Loanable funds Net capital outflow

r r
S1
r2 r2
r1 r1
D2 NCO2
D1 NCO1
LF NCO
26
Capital flight from Mexico – 2
The increase in NCO Market for foreign-

causes an increase in currency exchange
the supply of pesos in E S1 = NCO1
the foreign exchange S2 = NCO2
market.
E1
The real exchange rate
value of the peso falls. E2
D1
Pesos
27
Examples of capital flight: Mexico, 1994
0.35
US Dollars per currency unit .
0.30
0.25
0.20
0.15
0.10
10/23/1994
11/12/1994
12/22/1994
12/2/1994
1/11/1995
1/31/1995
2/20/1995
3/12/1995
4/1/1995
28
Examples of capital flight: S.E. Asia, 1997
120 South Korea Won
Thai Baht
US Dollars per currency unit.
100 Indonesia Rupiah
80
1/1/1997 = 100
60
40
20
0
12/1/1996
2/24/1997
5/20/1997
8/13/1997
11/6/1997
1/30/1998
4/25/1998
7/19/1998
29
Examples of capital flight: Russia, 1998
0.20
US Dollars per currency unit .
0.16
0.12
0.08
0.04
0.00
10/12/1998
11/21/1998
12/31/1998
6/14/1998
7/24/1998
5/5/1998
9/2/1998
30
Examples of capital flight: Argentina, 2002
1.2
U.S. Dollars per currency unit .
1.0
0.8
0.6
0.4
0.2
0.0
7/1/2001
9/19/2001
12/8/2001
2/26/2002
5/17/2002
8/5/2002
10/24/2002
1/12/2003
31
ASK THE EXPERTS
Currency Manipulation
“Economic analysis can identify whether
countries are using their exchange rates to
benefit their own people at the expense of their
trading partners’ welfare.”
Source: IGM Economic Experts Panel, June 16, 2015.
32
Capital Flows from China
• China accumulated foreign (including U.S.) assets:
– From 2000 to 2014, increased from $160 billion to
$4 trillion (including U.S. government bonds)
– But from 2016 to 2018: China's reserves of foreign
assets fell by almost $1 trillion
• Results in U.S.:
– Appreciation of $ relative to Chinese renminbi
– Higher U.S. imports from China
– Larger U.S. trade deficit
– The inflow of capital reduced U.S. interest rates,
increasing investment in the U.S. economy
33
THINK-PAIR-SHARE – 1
Hong Kong has a capitalistic economic
system. It was leased from China by Great
Britain for 100 years. In 1997, it was returned
to China, at the time a more socialistic country.
A. What do you think this event did to the net capital
outflow of Hong Kong in the years immediately
following 1997? Why?
34
THINK-PAIR-SHARE – 2
B. In the years immediately following 1997, the
residents of Hong Kong chose Canada as a place
to move some of their business activity. What
impact do you suppose this had on the value of
the Canadian interest rate and exchange rate?
Why?
C. Which Canadian industries, those engaged in
importing or exporting, were pleased with Hong
Kong’s investment in Canada? Why?
D. What impact did Hong Kong’s return to China
have on the growth rate of Canada in the years
immediately following 1997?
35
CHAPTER IN A NUTSHELL
• Market for loanable funds: real interest rate
adjusts to balance supply of loanable funds (from
national saving) and demand for loanable funds
(for domestic investment and net capital outflow).
• Market for foreign-currency exchange: real
exchange rate adjusts to balance supply of
dollars (from net capital outflow) and demand for
dollars (for net exports).
• Connecting them: net capital outflow. Contributes
to the demand for loanable funds and also
provides the supply of dollars for foreign-currency
exchange.
36
• A policy that reduces national saving, such as a
government budget deficit, reduces the supply of
loanable funds and drives up the interest rate. It
causes net capital outflow to decline, reducing
supply of dollars in the market for foreign-
currency exchange. The dollar appreciates, and
net exports fall.
• Political instability can lead to capital flight, which
tends to increase interest rates and cause the
currency to depreciate.
37
• Although restrictive trade policies, such as tariffs
or quotas on imports, are sometimes advocated
as a way to alter the trade balance, they do not
necessarily have that effect. A trade restriction
increases net exports for any given exchange
rate and, therefore, increases the demand for
dollars in the market for foreign-currency
exchange. As a result, the dollar appreciates,
making domestic goods more expensive relative
to foreign goods. This appreciation offsets the
initial impact of the trade restriction on net
exports.
38

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N.

GREGORY MANKIW NINTH EDITION

Loanable funds • Both I and NCO

Source: IGM Economic Experts Panel, June 21, 2017.

Loanable funds Net capital outflow

The increase in NCO Market for foreign-

100 Indonesia Rupiah

Source: IGM Economic Experts Panel, June 16, 2015.

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