Chapter 8

Principles of

Macroeconomics, Fourth Edition

Instructor’s Manual

The Open Economy

•  Open economy: trades goods and services and capital with the rest of the world

(ROW)

•  Investment and the government deficit can be financed by domestic savings by

households or by foreigners.

•  (Sp + Sg) + NCF = I, where NCF = net capital flows

•  When NCF > 0, capital flows into the U.S. economy from ROW.

•  When NCF < 0, capital flows out of the U.S. economy to ROW.

Switzerland (a)

•  Switzerland is a small open economy.

•  The Swiss must take the real‑world interest rate as their own (ignore risk).

•  If rSwiss < r* where r* is the world real interest rate, then Switzerland would have

no capital.

•  All the capital would leave the country for the higher returns abroad (this

assumes there are no restrictions on the export of capital, called capital

controls).

•  There is no reason to offer rSwiss > r* since the country can get all the capital it

needs from the ROW by offering r*.

Switzerland (b)

•  Switzerland faces an infinitely elastic (horizontal) supply of capital at r*.

•  Investment spending is still a negative function of the real interest rate.

•  For Switzerland r = r* so the real interest rate cannot adjust to changes domestically,

therefore NCF must adjust to maintain equilibrium of leakages = injections.

Switzerland (c)

•  Supply of savings in a small open economy.

•  B0 = original international borrowing

•  B1 = new international borrowing

Suppose Government Spending Increases

•  Suppose G ↑ in a small open economy at full employment.

•  As before, national savings S ↓ because government savings Sg ↓.

•  The saving curve shifts left.

•  Since r = r*, a gap opens between national savings and investment.

•  This gap is NCF; foreign capital flows into the economy to make up the difference

between national savings and total investment.

•  In a small open economy there is no crowding out of investment!

•  Downside: Increased foreign borrowing must be repaid in the future

•  These payments to foreigners may lower future living standards.

The United States Economy (a)

•  The United States is a large open economy.

•  Changes in the United States have effects on the world real interest rate r*.

•  U.S. savings account for 20% of world savings.

•  A decrease in U.S. savings would raise world interest rates.

•  This chokes off some U.S. investment as in the closed economy case, but the

magnitude of crowding out would be lower due to foreign capital inflows.

The United States Economy (b)

•  In the decades after World War II, if U.S. savings fell by $1 billion, U.S. investment fell

by about $1 billion as in a closed economy.

•  Today if U.S. savings fell by $1 billion, investment would only fall by between $350

and $500 million.

•  This implies that today foreigners are more able and willing to invest in the United

States.

Determination of the Trade Balance

•  Sp + Sg + NCF = I

•  Remember, Sp = Yf ‑ T ‑ C, and Sg = T – G

•  Using these expressions we can write:

•  (Yf – T – C) + (T – G) + NCF = I

•  From equilibrium of expenditure and output we have:

•  Yf = C + I + G + NX in full-employment equilibrium

•  Using this for Yf above and simplifying we get:

•  NX + NCF = 0

Net Exports plus Net Capital Flows

•  Net exports + net capital flows = 0.

•  If NX < 0, then NCF > 0.

•  A trade deficit (NX < 0) must be financed by capital inflows (NCF > 0).

•  Rewrite this as NCF + Exports ‑ Imports = 0.

•  NCF + Exports = Imports. A country's imports are paid for out of revenues earned

from exports plus any capital inflows.

The U.S. Fiscal Deficit and Trade Deficit

•  The trade deficit and government budget deficit often move together but not always

•  In the 1980s increases in the budget deficit were accompanied by increases in foreign

borrowing and a trade deficit. During the late 1990s the fiscal deficit fell but the trade

deficit increased.

National Saving, Investment and Net Capital Flows

•  In the 1980s national saving fell while investment rose so the United States had a

large capital inflow. In the early 1990s national saving rose and capital inflows fell. By

2000 national saving had declined and net capital inflows increased.

What happened?

•  The 1980s saw a downward trend in Sp.

•  Investment rose until 1984, then fell.

•  NCF rose until late in the 1980s, so borrowing from foreigners increased to pay for the

government deficit.

•  In the 1990s, the government deficit fell after 1991, so ΔSg > 0.

•  This allowed other variables to increase.

•  Sp rose after 1991.

•  Investment rose after 1991.

•  NCF rose after 1991.

U.S. Imports and Exports

•  Insert figure (unlabelled) from chapter 8 of the macro split of the 4th edition of Stiglitz

and Walsh in E-Insight Box on High-Tech Exports and Imports

Exchange Rates

•  Exchange rates: how much of one country's currency trades for a given amount of

another country's currency

•  The bilateral exchange rate e is the exchange rate between two countries' currencies.

•  e = Japanese yen/U.S. dollar = 105 yen/$1

•  If e increases to 120 yen/$1, then the dollar buys more yen. The dollar

appreciates against the yen or the yen depreciates against the dollar

The Trade-Weighted Value of the U.S. Dollar

•  The trade-weighted exchange rate is the weighted average of the exchange rates

between the dollar and the currencies of our major trading partners.

Trade‑Weighted Exchange Rate (b)

•  The U.S. trade‑weighted exchange rate peaked in 1985—the Golden Dollar.

•  In the early 1990s it fluctuated around a steady value.

•  From the mid-1990s the dollar increased in value against the currencies of our major

trading partners.

•  Since 2002 the dollar has lost value.

The Supply of U.S. Dollars

•  U.S. citizens’ supply of dollars to buy foreign goods and investments

•  The supply curve is upward sloping.

•  If e ↑, foreign currency and foreign goods are cheaper, so U.S. residents supply a

greater quantity of dollars.

•  The supply curve of dollars shifts when U.S. residents wish to:

•  Buy more imported goods

•  Invest more in foreign countries

•  Take more trips abroad

The Demand for U.S. Dollars

•  The demand curve for dollars represents the demand by foreigners for U.S. currency.

•  The demand curve is downward sloping.

•  If e ↑, the dollar is more expensive to foreigners so they buy fewer dollars.

•  The demand curve for dollars shifts right when foreigners want to:

•  Buy more U.S. exports

•  Invest more in the United States

•  Take more trips to the United States

Equilibrium

The Effects of Increased Foreign Borrowing

•  Suppose the United States borrows more from foreigners, say, from Japan.

•  To attract Japanese investors, the U.S. interest rate must rise.

•  The increased demand for dollars by Japanese investors shifts the demand curve for

dollars to the right since high U.S. interest rates make U.S. investments attractive to

Japanese investors.

•  The supply of dollars shifts to the left because Japanese investments are less

attractive to U.S. investors.

•  In equilibrium there is a higher exchange rate; the dollar appreciates against the yen.

•  Fluctuations in the exchange rate ensure that the trade balance and foreign borrowing

move together; that is, NX + NCF = 0.

The Effects of Increased Foreign Borrowing (continued)

Is the Trade Deficit a Problem?

•  A trade deficit implies an increase in foreign borrowing.

•  Like any borrowing this may be good or bad, but it certainly must be repaid.

•  The benefits of a trade deficit and the associated borrowing depend on how the

borrowed funds are used.

•  If the borrowing finances investment, which increases the capital stock and

boosts future income, then this will help the country pay foreigners in the future

without reducing consumption.

•  On the other hand, if the trade deficit finances current consumption, by either

consumers or the government, then future generations are worse off because

they get no benefits from the current trade deficit but bear the costs of repayment.

This concludes the Instructor’s Manual Slide Set for Chapter 8

Principles of

Macroeconomics, Fourth Edition

by Joseph E. Stiglitz

Carl E. Walsh

W. W. Norton & Company Independent and Employee-Owned