Open Macroeconomic Economy Part 2 (Chapter 32)

Open Macroeconomic Economy Part 2 (Chapter 32)

Open Macroeconomic Economy Part 2 (Chapter 32) Barnett UHS AP Econ 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 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 The Market for Loanable Funds Recall: S depends positively on the real interest rate, r. I depends negatively on r. What about NCO? 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 Net capital outflow r1 r2 NCO NCO NCO1 NCO2 The Loanable Funds Market Diagram r adjusts to balance supply and demand in the LF market. r

Loanable funds S = saving Both I and NCO depend negatively on r, so the D curve is downward-sloping. r1 D = I + NCO LF ACTIVE LEARNING 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. 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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 for classroom use. ACTIVE LEARNING 1 Answers When working with this model, keep in mind: The higher r makes U.S. saving bonds and morethe attractive relative A budget deficit reduces supply of LF, the LF market determines r (in left graph), to foreignr to

bonds, causing rise. reduces NCO. then this value of r determines NCO (in right graph). Loanable funds Net capital outflow r r S2 S1 r2 r2 r1 r1 D1 NCO1 LF 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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 for classroom use.

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. 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. The Market for Foreign-Currency Exchange Anadjusts increase in E makes E to balance U.S. goods more supply and demand E expensive to the foreigners, for dollars in reducesfor foreign demand market foreignfor U.S. goodsand

currency exchange. U.S. dollars. E1 An increase in E has no effect on saving or investment, so it does not affect NCO or the supply of dollars. S = NCO D = NX Dollars 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, its more convenient to use the second. 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. ACTIVE LEARNING 2 Budget deficit, exchange rate, and 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? 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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 for classroom use. ACTIVE LEARNING 2 Answers The budget deficit reduces NCO and the supply of dollars. Market for foreigncurrency exchange S2 = NCO2 E

The real exchange rate appreciates, E2 reducing net exports. E1 Since NX = 0 initially, the budget deficit causes a trade deficit (NX < 0). S1 = NCO1 D = NX Dollars 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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 for classroom use. The Twin Deficits

Net exports and the budget deficit often move in opposite directions. 6% 4% U.S. federal budget deficit 3% 2% -4% -5% 2006-2010 2001-2005 1991-95 1986-90

U.S. net exports 1996-2000 -3% 1981-85 -2% 1976-80 -1% 1971-75 0% 1966-70 1% 1961-65

Percent of GDP 5% 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) SUMMARY: The Effects of a Budget Deficit One other effect: As foreigners acquire more domestic assets, the countrys debt to the rest of the world increases. Due to many years of budget and trade deficits, the U.S. is now the worlds largest debtor nation. International Investment Position of the U.S. 31 December 2009 Value of U.S.-owned foreign assets $18.4 trillion

Value of foreign-owned U.S. assets $21.1 trillion U.S. net debt to the rest of the world $2.7 trillion The Connection Between Interest Rates and Exchange Rates Keepthat in mind: Anything increases r (not shown) The LF market determines will reduce NCOr. Thissupply

value of and the of r then determines NCO dollars in the foreign (shown in upper graph). exchange market. This value of NCO then Result: determines supply of The real exchange dollars in foreign exchange rate appreciates. market (in lower graph). r r2 r1 NCO

NCO NCO2 E S2 NCO1 S1 = NCO1 E2 E1 D = NX dollars NCO2 NCO1 ACTIVE LEARNING 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 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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 for classroom use. ACTIVE LEARNING 3 Answers rInvestmentand rises, the demand for LFincrease at each causing

to fall. value of NCO r. r Loanable funds Net capital outflow r S1 r2 r2 r1 r1 D1 D2 NCO LF

NCO NCO2 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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 for classroom use. NCO1 ACTIVE LEARNING 3 Answers The fall in NCO reduces the supply of dollars in the foreign exchange market. The real exchange rate appreciates, Market for foreigncurrency exchange

S2 = NCO2 E S1 = NCO1 E2 E1 reducing net exports. D = NX Dollars 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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 for classroom use. 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. 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 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? Lets 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. Analysis of a Quota on Cars from Japan An import quota does not affect saving or investment, so it does not affect NCO. (Recall: NCO = S I.) r Loanable funds r Net capital outflow S r1 r1 D NCO LF NCO

Analysis of a Quota on Cars from Japan Since NCO 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 eqm. Market for foreigncurrency exchange E S = NCO E2 E1 D2 D1 Dollars

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. 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!! 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 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. 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 NCO 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 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

0 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 .

Examples of Capital Flight: Argentina, 2002 1.2 1.0 0.8 0.6 0.4 0.2 0.0

Recently Viewed Presentations

  • Tennis Rackets (1) - Kansas State University

    Tennis Rackets (1) - Kansas State University

    Times New Roman Tennis Rackets Tennis Rackets PowerPoint Presentation Throat Shapes Frame Designs Playing and String Characteristics PowerPoint Presentation Swing Weights (From Racquet Tech Sept, 1999) Summary of "The modern tennis racquet" by Howard Brody (1996) Brody article, cont'd Brody...
  • Heredity and Reproduction

    Heredity and Reproduction

    The process of pollination can happen from wind, insects, birds, and other animals carrying and transferring the pollen from the stamen to the pistil. Although bees are the insect who are most famous for pollination, many other insects also help...
  • CONNECTIVE TISSUE III. CONNECTIVE TISSUES A. GENERAL CHARACTERISTICS

    CONNECTIVE TISSUE III. CONNECTIVE TISSUES A. GENERAL CHARACTERISTICS

    1. Connective tissues function to bind structures, provide support and protect, serve as frameworks, fill spaces, store fat, produce blood cells, protect against infections, and help repair tissue damage. 2. Matrix of connective tissue is extracellular material.
  • Siddharth Infra Power Pvt Ltd

    Siddharth Infra Power Pvt Ltd

    He is an eminent elect engg with wide exp in projects,maintenance,trading with working exp in many reputed companies like ITC, Steel authority of India. He is a CA and ex- banker having more than 10 years exp. He works on...
  • SAARF Lifestyles AMPS Dec11 Update How were the

    SAARF Lifestyles AMPS Dec11 Update How were the

    Visit a game reserve. Exercise. Go on a diet. Use slimming preparations to lose weight. Meet friends at a book club. Go to a pub/shebeen/tavern. Go to a dinner party. Have a braai. Go to restaurant/steak house. Meet at burial...
  • Customer Experience Excellence 3rd April 2014 What is

    Customer Experience Excellence 3rd April 2014 What is

    Gartner 2014 * UCLH Context Unclear vision, disjointed, multiple definitions 3rd year of Making A Difference Together Campaign Learning from 'Best in Class' organisations characterised by excellence in customer experience Transformation Programme ICT vision - Customer Relationship Management (CRM) *...
  • Ethical Guidelines for Research

    Ethical Guidelines for Research

    HPTN Ethics Guidance for Research Kathleen M. MacQueen (FHI) Jeremy Sugarman (Duke University) On behalf of the HPTN Ethics Working Group Quarraisha Abdool Karim (Chair), Ronald Bayer, Solomon R. Benatar, Marge Chigwanda, Dennis Dixon, Deborah Donnell, Laura Guay, Stella Kirkendale,...
  • XML i nowoczesne technologie zarządzania treścią

    XML i nowoczesne technologie zarządzania treścią

    Technologie zarządzania wiedzą Szymon Zioło [email protected] Tendencje w biznesie Modne hasło: zarządzanie wiedzą Wiedza - najcenniejszy zasób w organizacji.