Open Economy in the Long Run - University of North Texas · Open Economy in the Long Run Intermediate Macroeconomic Theory Macroeconomic Analysis University of North Texas ECON 3560

Open Economy in the Long Run

Intermediate Macroeconomic TheoryMacroeconomic Analysis

University of North Texas

ECON 3560 / 5040 Open Economy in the Long Run

Outline

1 International Flows of Capital and Goods

2 Saving and Investment in a Small Open Economy

3 Exchange Rates


Outline



3 Exchange Rates


International Flows of Capital and Goods

National income accounts identity

⇒ Y = Cd + Id + Gd + EX =

⇒ Y = C + I + G + EX − IM

1 International flow of goods and services: NX = Y − (C + I + G)

2 International flow of (financial) capital: S − I = NX

The national income accounts identity shows the internationalflow of funds to finance capital accumulation and theinternational flow of goods and services are two sides of thesame coin




⇒ Y = Cd + Id + Gd + EX =

⇒ Y = C + I + G + EX − IM







⇒ Y = Cd + Id + Gd + EX =

⇒ Y = C + I + G + EX − IM







⇒ Y = Cd + Id + Gd + EX =

⇒ Y = C + I + G + EX − IM







⇒ Y = Cd + Id + Gd + EX =

⇒ Y = C + I + G + EX − IM


Y > C + I + G⇒ NX > 0 (trade surplus)

Y < C + I + G⇒ NX < 0 (trade deficit)

Y = C + I + G⇒ NX = 0 (balanced trade)






⇒ Y = Cd + Id + Gd + EX =

⇒ Y = C + I + G + EX − IM







⇒ Y = Cd + Id + Gd + EX =

⇒ Y = C + I + G + EX − IM



S > I ⇒ NX > 0

S < I ⇒ NX < 0

S = I ⇒ NX = 0





⇒ Y = Cd + Id + Gd + EX =

⇒ Y = C + I + G + EX − IM





Outline



3 Exchange Rates


The Classical Model for a Small Open Economy

Assuming a small open economy with perfect capital mobility,r = r∗

The model

1 Y = F(K, L) = Y

2 C = C(Y − T)

3 I = I(r∗)

4 G = G

Trade balance is determined net capital outflow at the worldinterest rate

⇒ NX = S − I = (Y − C − G)− I(r∗)




A small economy has a negligible effect on world saving andworld investment

The model

1 Y = F(K, L) = Y

2 C = C(Y − T)

3 I = I(r∗)

4 G = G


⇒ NX = S − I = (Y − C − G)− I(r∗)




The model

1 Y = F(K, L) = Y

2 C = C(Y − T)

3 I = I(r∗)

4 G = G


⇒ NX = S − I = (Y − C − G)− I(r∗)




The model

1 Y = F(K, L) = Y

2 C = C(Y − T)

3 I = I(r∗)

4 G = G


⇒ NX = S − I = (Y − C − G)− I(r∗)




The model

1 Y = F(K, L) = Y

2 C = C(Y − T)

3 I = I(r∗)

4 G = G


⇒ NX = S − I = (Y − C − G)− I(r∗)




The model

1 Y = F(K, L) = Y

2 C = C(Y − T)

3 I = I(r∗)

4 G = G


⇒ NX = S − I = (Y − C − G)− I(r∗)




The model

1 Y = F(K, L) = Y

2 C = C(Y − T)

3 I = I(r∗)

4 G = G


⇒ NX = S − I = (Y − C − G)− I(r∗)




The model

1 Y = F(K, L) = Y

2 C = C(Y − T)

3 I = I(r∗)

4 G = G


⇒ NX = S − I = (Y − C − G)− I(r∗)




The model

1 Y = F(K, L) = Y

2 C = C(Y − T)

3 I = I(r∗)

4 G = G


⇒ NX = S − I = (Y − C − G)− I(r∗)


The Classical Model for a Small Open EconomyHow Policies Influence the Trade Balance

Assumption: a position of balanced trade (NX = 0)

1 Fiscal policy at home

↑ G(↓ T) ⇒ NX < 0

2 Fiscal policy abroad

↑ G∗(↓ T∗) ⇒ NX > 0

3 Shifts in investment demand

↑ I ⇒ NX < 0





↑ G(↓ T) ⇒ NX < 0


↑ G∗(↓ T∗) ⇒ NX > 0


↑ I ⇒ NX < 0





↑ G(↓ T) ⇒ NX < 0


↑ G∗(↓ T∗) ⇒ NX > 0


↑ I ⇒ NX < 0





↑ G(↓ T) ⇒ NX < 0


↑ G∗(↓ T∗) ⇒ NX > 0


↑ I ⇒ NX < 0





↑ G(↓ T) ⇒ NX < 0


↑ G∗(↓ T∗) ⇒ NX > 0


↑ I ⇒ NX < 0





↑ G(↓ T) ⇒ NX < 0


↑ G∗(↓ T∗) ⇒ NX > 0


↑ I ⇒ NX < 0





↑ G(↓ T) ⇒ NX < 0


↑ G∗(↓ T∗) ⇒ NX > 0


↑ I ⇒ NX < 0


Outline



3 Exchange Rates


Exchange RatesNominal Exchange Rates

Nominal exchange rate (e): the relative price of the currency oftwo countries

Nominal exchange rates are quoted as

1 Foreign currency per unit of domestic currency (dollar):europrean term

2 Domestic currency (dollars) per unit of foreign currency:american Term

Depreciation is a decrease in the value of a currency relative toanother currency

Appreciation is an increase in the value of a currency relative toanother currency






















⇒ How much can be exchanged for one dollar? U102/$1


















⇒ How much can be exchanged for one yen? $0.0098/U1




















Exchange RatesReal Exchange Rates

Real exchange rate (ε): the relative price of the goods of twocountries (= terms of trade)

⇒ ε = ePP∗

1 If ε is high (real appreciation), foreign goods are relatively cheap,and domestic goods are relatively expensive

2 If ε is low (real depreciation), foreign goods are relativelyexpensive, and domestic goods are relatively cheap

⇒ NX = NX(ε)




⇒ ε = ePP∗



⇒ NX = NX(ε)




⇒ ε = ePP∗



⇒ NX = NX(ε)




⇒ ε = ePP∗



⇒ NX = NX(ε)




⇒ ε = ePP∗



⇒ NX = NX(ε)


Exchange RatesThe Determinants of the Real Exchange Rate

From NX = NX(ε) and S − I = NX,

⇒ At the equilibrium real exchange rate, the supply of dollarsavailable for net capital outflow balances the demand for dollarsby foreigners buying our net exports

How policies influence the real exchange rate




4 Protectionist trade policies
























































Exchange RatesCase Study: The Reagan Deficits Revisited

Reagan policies during early 1980s: (T − G) ⇓


Exchange RatesCase Study: The Reagan Deficits Revisited

Reagan policies during early 1980s: (T − G) ⇓

-

-

↓

↑

↓

↑

↑

↓

-

-

↓

↑

↑

↓

-

↑

↓

↑

129.4

-2.0

19.4

6.3

17.4

3.9

115.1

-0.3

19.9

1.1

19.6

2.2

closed economy

small open economy

actual change

ε

NX

I

r

S

G – T

1980s1970s

Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index.


Exchange RatesNominal Exchange Rate and Inflation

The determinants of the nominal exchange rate:

ε = ePP∗ ⇒ e = ε · P∗

P

1 Given ε, if ↑ P, a dollar is worth less and a dollar will buy fewerforeign currency (↓ e)

2 Given ε, if ↑ P∗, a dollar is worth more and a dollar will buy moreforeign currency (↑ e)

Inflation differential and nominal exchange rate

%∆e = %∆ε + (%∆P∗ −%∆P)

⇒ If a country has a high (low) rate of inflation relative to theUS, a dollar will buy an increasing (decreasing) amount of theforeign currency overtime




ε = ePP∗ ⇒ e = ε · P∗

P




%∆e = %∆ε + (%∆P∗ −%∆P)





ε = ePP∗ ⇒ e = ε · P∗

P




%∆e = %∆ε + (%∆P∗ −%∆P)





ε = ePP∗ ⇒ e = ε · P∗

P




%∆e = %∆ε + (%∆P∗ −%∆P)





ε = ePP∗ ⇒ e = ε · P∗

P




%∆e = %∆ε + (%∆P∗ −%∆P)





ε = ePP∗ ⇒ e = ε · P∗

P




%∆e = %∆ε + (%∆P∗ −%∆P)





ε = ePP∗ ⇒ e = ε · P∗

P




%∆e = %∆ε + (%∆P∗ −%∆P)





Percentage changein nominalexchange rate

10

9

8

7

6

5

4

3

2

1

0

-1

-2

-3

-4

Inflation differential

Depreciationrelative to U.S. dollar

Appreciationrelative to U.S. dollar

-1-2-3 10 2 3 4 5 6 87

France

Canada

SwedenAustralia

UK

Ireland

Spain

South Africa

Italy

New Zealand

NetherlandsGermany

Japan

Belgium

Switzerland


Documents

Open Economy in the Long Run - University of North Texas · Open Economy in the Long Run Intermediate Macroeconomic Theory Macroeconomic Analysis University of North Texas ECON 3560