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Macroeconomics, Masaryk University
Spring 2017
Lecture 9: A Macroeconomic Theory of the Open Economy
Nikoloz Kudashvili
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Seventh Edition
Macroeconomics
Principles of
N. Gregory Mankiw
CHAPTER
19
A Macroeconomic
Theory of the
Open Economy
WojciechGerson(1831-1901)
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 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?
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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…
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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
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The Market for Loanable Funds
 Recall:
 S depends positively on the real interest rate, r.
 I depends negatively on r.
 What about NCO?
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6
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
relative to foreign assets.
 People in the U.S.
purchase more foreign
assets.
 People abroad purchase
fewer U.S. assets.
 NCO rises.
r
NCO
NCO
r2
Net capital outflow
r1
NCO1 NCO2
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7
D = I + NCO
r adjusts to balance supply
and demand in the LF market.
The Loanable Funds Market Diagram
r
LF
S = saving
Loanable funds
r1
Both I and NCO
depend negatively on r,
so the D curve is
downward-sloping.
A C T I V E L E A R N I N G 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.
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A C T I V E L E A R N I N G 1
Answers
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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.
D1
r
NCO
NCO1
Net capital outflow
r
LF
S1
Loanable funds
r1
S2
r2r2
r1
When working with this model, keep in mind:
the LF market determines r (in left graph),
then this value of r determines NCO (in right graph).
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10
The Market for Foreign-Currency Exchange
 Another identity from the preceding chapter:
NCO = NX
Net exports
Net capital
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.
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11
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.
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12
S = NCO
The Market for Foreign-Currency Exchange
E
Dollars
D = NX
E1
An increase in E
has no effect on
saving or investment,
so it does not affect
NCO or the supply of
dollars.
E adjusts to balance
supply and demand
for dollars in the
market for foreigncurrency
exchange.
An increase in E makes
U.S. goods more
expensive to foreigners,
reduces foreign demand
for U.S. goods—and
U.S. dollars.
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13
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.
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14
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.
A C T I V E L E A R N I N G 2
Budget deficit, exchange rate, 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?
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A C T I V E L E A R N I N G 2
Answers
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The budget deficit
reduces NCO and the
supply of dollars.
The real exchange
rate appreciates,
reducing net exports.
Since NX = 0 initially,
the budget deficit
causes a trade deficit
(NX < 0).
S1 = NCO1
E
Dollars
D = NX
E1
S2 = NCO2
E2
Market for foreigncurrency
exchange
The “Twin
Deficits”
Net exports and the budget deficit
often move in opposite directions.
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
1961-65
1966-70
1971-75
1976-80
1981-85
1986-90
1991-95
1996-2000
2001-2005
2006-2010
PercentofGDP
U.S. federal
budget deficit
U.S. net exports
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SUMMARY: 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.
 Net exports fall (or, the trade deficit increases).
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19
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 October 2013
Value of U.S.-owned foreign assets $21.6 trillion
Value of foreign-owned U.S. assets $25.8 trillion
U.S.’ net debt to the rest of the world $ 4.2 trillion
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20
The Connection
Between
Interest Rates
and Exchange Rates
r
NCO
E
dollars
NCO
D = NX
S1 = NCO1S2
E1
E2
r1
r2
Anything that
increases r
will reduce NCO
and the supply of
dollars in the foreign
exchange market.
Result:
The real exchange
rate appreciates.
NCO1NCO2
NCO1NCO2
Keep in mind:
The LF market (not shown)
determines r.
This value of r
then determines NCO
(shown in upper graph).
This value of NCO then
determines supply of
dollars in foreign exchange
market (in lower graph).
A C T I V E L E A R N I N G 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
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A C T I V E L E A R N I N G 3
Answers
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D1
r
NCO
NCO
Net capital outflow
r
LF
S1
Loanable funds
r1 r1
r2
D2
r2
r rises,
causing NCO to fall.
NCO1NCO2
Investment—and the demand for LF—increase at each
value of r.
A C T I V E L E A R N I N G 3
Answers
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The fall in NCO
reduces the
supply of dollars
in the foreign
exchange market.
The real exchange
rate appreciates,
reducing net exports.
S1 = NCO1
E
Dollars
D = NX
E1
S2 = NCO2
E2
Market for foreigncurrency
exchange
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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.
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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
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26
Trade Policy
 Common reasons for policies that 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.
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27
D
An import quota does not affect saving or investment,
so it does not affect NCO. (Recall: NCO = S – I.)
Analysis of a Quota on Cars from Japan
r
NCO
NCO
Net capital outflow
r
LF
S
Loanable funds
r1 r1
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28
Analysis of a Quota on Cars from Japan
Since NCO is unchanged,
S curve does not shift.
The D curve shifts:
At each E,
imports of cars fall,
so net exports rise,
D shifts to the right.
At E1, there is excess
demand in the foreign
exchange market.
E rises to restore eq’m.
S = NCOE
Dollars
D1
E1
Market for foreigncurrency
exchange
D2
E2
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29
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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30
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!!
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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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32
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
perspective of Mexico, not the U.S.
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33
The equilibrium values of r and NCO both increase.As foreign investors sell their assets and pull out their
capital, NCO increases at each value of r.
Demand for LF = I + NCO.
The increase in NCO increases demand for LF.
D1
Capital Flight from Mexico
r
NCO
NCO1
r1
Net capital outflow
r
LF
S1
r1
Loanable funds
D2
r2
NCO2
r2
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34
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.
S2 = NCO2
Market for foreigncurrency
exchange
E
Pesos
D1
S1 = NCO1
E1
E2
Examples of Capital Flight: Mexico, 1994
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
4/1/1995
USDollarspercurrencyunit.
Examples of Capital Flight: S.E. Asia, 1997
0
20
40
60
80
100
120
12/1/1996
2/24/1997
5/20/1997
8/13/1997
11/6/1997
1/30/1998
4/25/1998
7/19/1998
USDollarspercurrencyunit.
1/1/1997=100
South Korea Won
Thai Baht
Indonesia Rupiah
Examples of Capital Flight: Russia, 1998
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
12/31/1998
USDollarspercurrencyunit.
Examples of Capital Flight: Argentina, 2002
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
1/12/2003
U.S.Dollarspercurrencyunit.
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39
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.
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40
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.
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.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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.
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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.
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