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CHAPTE R 32 A Macroeconomic Theory of the Open Economy Economics N Gregory PRINCIPLES OF Mankiw Premium PowerPoint Slides by Ron Cronovich © 2009 South-Western, a part of Cengage Learning, all rights reserved In this chapter, look for the answers to these questions:  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 government budget deficits affect the exchange rate and trade balance?  How other policies or events affect the interest rate, exchange rate, and trade balance? Introduction  The previous chapter explained the basic concepts and vocabulary of the open economy: net exports (NX), net capital outflow (NCO), and exchange rates  This chapter ties these concepts together into a theory of the open economy  We will use this theory to see how govt policies and various events affect the trade balance, exchange rate, and capital flows  We start with the loanable funds market… A MACROECONOMIC THEORY OF THE OPEN ECONOMY The Market for Loanable Funds  An identity from the preceding chapter: S = I + NCO Saving Domestic investment Net capital 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  So, demand for loanable funds = I + NCO A MACROECONOMIC THEORY OF THE OPEN ECONOMY 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 How NCO Depends on the Real Interest Rate The real interest rate, r, is the real return on domestic assets A fall in r makes domestic assets less attractive r1 relative to foreign assets  People in the U.S r2 purchase more foreign assets  People abroad purchase fewer U.S assets  NCO rises r Net capital outflow NCO NCO NCO1 NCO2 A MACROECONOMIC THEORY OF THE OPEN ECONOMY The Loanable Funds Market Diagram rr adjusts adjusts to to balance balance supply supply and and demand demand in in the the LF LF market market r Loanable funds S = saving r1 D = I + NCO Both Both II and and NCO NCO depend depend negatively negatively on on r, r, so so the the D D curve curve is is downward-sloping downward-sloping LF A MACROECONOMIC THEORY OF THE OPEN ECONOMY ACTIVE LEARNING 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 When working with this model, keep in ACTIVE LEARNING the LF market determines r (in left graph) Answersthen this value of r determines NCO (in right gr The higher r makes U.S bonds more attractive relative to foreign bonds, reduces NCO r Loanable funds S2 r Net capital outflow S1 r2 r2 r1 r1 D1 NCO1 LF NCO The Market for Foreign-Currency Exchange  Another identity from the preceding chapter: NCO = NX Net capital outflow Net exports  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 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 10 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 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 31 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 ECONOMY 32 Capital Flight from Mexico Demand The equilibrium forinvestors LF =values I + sell NCO oftheir r and NCOand bothpull increase As foreign assets out their The increase in NCO increases demand capital, NCO increases at each value of r.for LF r Loanable funds r Net capital outflow S1 r2 r2 r1 r1 D1 D2 NCO2 NCO1 LF A MACROECONOMIC THEORY OF THE OPEN ECONOMY NCO 33 Capital Flight from Mexico The increase in NCO causes an increase in the supply of pesos in the foreign exchange market The real exchange rate value of the peso falls Market for foreigncurrency exchange E S1 = NCO1 S2 = NCO2 E1 E2 D1 Pesos A MACROECONOMIC THEORY OF THE OPEN ECONOMY 34 4/1/1995 3/12/1995 2/20/1995 1/31/1995 1/11/1995 12/22/1994 12/2/1994 11/12/1994 10/23/1994 US Dollars per currency unit Examples of Capital Flight: Mexico, 1994 0.35 0.30 0.25 0.20 0.15 0.10 7/19/1998 100 4/25/1998 120 1/30/1998 11/6/1997 8/13/1997 5/20/1997 2/24/1997 12/1/1996 1/1/1997 = 100 US Dollars per currency unit Examples of Capital Flight: S.E Asia, 1997 South Korea Won Thai Baht Indonesia Rupiah 80 60 40 20 12/31/1998 11/21/1998 10/12/1998 9/2/1998 7/24/1998 6/14/1998 5/5/1998 US Dollars per currency unit Examples of Capital Flight: Russia, 1998 0.20 0.16 0.12 0.08 0.04 0.00 1/12/2003 10/24/2002 8/5/2002 5/17/2002 2/26/2002 12/8/2001 9/19/2001 7/1/2001 U.S Dollars per currency unit 1.2 Examples of Capital Flight: Argentina, 2002 1.0 0.8 0.6 0.4 0.2 0.0 CASE STUDY: The Falling Dollar 90 U.S trade-weighted nominal exchange rate index, March 1973 = 100 From 10/2005 to 6/2008, the dollar depreciated 17.3% 85 80 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 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 40 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 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 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 separate myth from reality A MACROECONOMIC THEORY OF THE OPEN ECONOMY 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 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