Chapter 19 Notes: Open Economy Macroeconomics

Chapter 19: Macroeconomic Theory of the Open Economy

Learning Objectives

• Determining real interest rates and exchange rates in an open economy.

• Understanding the connection between markets for loanable funds and foreign currency exchange.

• Analyzing the impact of government budget deficits on exchange rates and trade balance.

• Evaluating the effects of policies and events on interest rates, exchange rates, and trade balance.

Macroeconomic Identities (Review from Chapter 13)

• Private Saving: Y - T - C where:

  • Y = Income

  • T = Taxes

  • C = Consumption

• Public Saving: T - G where:

  • T = Taxes

  • G = Government Spending

• National Saving: Private Saving + Public Saving = Y - C - G

• Closed Economy: Investment = National Saving (I = S)

Open Economy Identity (Chapter 18)

• National Saving = Investment + Net Capital Outflow (S = I + NCO)

• Net Capital Outflow (NCO) represents the difference between domestic purchase of foreign assets and foreign purchase of domestic assets.

Savings and Investment in Closed vs. Open Economies

• Closed Economy: Savings are loaned by banks and financial institutions to individuals for investment.

• Open Economy: Savings can be invested domestically (I) or in other countries (NCO).

Net Capital Outflow (NCO) Explained

• NCO: Domestic purchase of foreign assets - foreign purchase of domestic assets.

• Domestic citizens can invest in foreign countries through:

  • Foreign Direct Investment (e.g., opening a McDonald's).

  • Buying foreign bonds or stocks.

• When you buy a government bond from a foreign country, you are lending to that government, allowing them to invest.

• When you buy a stock from a foreign company, you become a partial owner, and your money is used for the company's investments.

Dependence on Interest Rate

• Savings, Investment, and NCO are all related to interest rate (r).

Savings vs Interest rate

• Savings increase with interest rate. If r increases, then Savings (S) also increases.

• If interest rate increases from r1 to r2, then savings increases from s1 to s2.

Investment vs Interest rate

• Investment decreases as interest rates rise. When r increases, Investment (I) decreases because investment becomes more expensive.

• If interest rate increases from r1 to r2, then investment decreases from I1 to I2.

NCO vs Interest rate

• NCO decreases when the home interest rate increases. If home interest rate (r) increases, NCO decreases.

• NCO = Domestic purchase of foreign assets - foreign purchase of domestic assets

• When home interest rate increases, domestic purchase of foreign assets decreases because domestic assets offer higher returns.

• Conversely, when home interest rates increase, foreign purchase of domestic assets increases.

• If interest rate increases from r1 to r2, then NCO decreases from NCO1 to NCO2.

Market for Loanable Funds in an Open Economy

• The market for loanable funds equates savings with the sum of investment and net capital outflow.

• Supply of loanable funds comes from saving, which increases with interest rate.

• Demand for loanable funds comes from investment * NCO.

• Equilibrium is where Savings = Investment + NCO.

• The equilibrium in the market for loanable funds determines r^ (equilibrium interest rate) and I + NCO^.

Sample Question: Government Budget Deficit

Scenario

A government runs a budget deficit after previously having a balanced budget. What impact does this have on interest rates and NCO?

Balanced Budget

• Initial supply of loan: S_1

• Initial demand for loan: D_1

• Equilibrium: E

• Interest rate: r_1

• Net capital outflow: NCO_1

Budget Deficit Impact

• A budget deficit reduces public saving, leading to a decrease in national saving. As a result, the supply of loanable funds shifts to the left.

• Supply of loan decreases from S1 to S2, equilibrium moves from E to F, and interest rate increases from r1 to r2.

• This increase in interest rate decreases NCO from NCO1 to NCO2.

Net Export (NX) and Exchange Rate (E)

• The relationship between net export and exchange rate can be graphically represented.

Net Export Curve

• Downward sloping.

• Net export decreases if exchange rate increases because when exchange rate increases, it becomes more expensive for foreign consumers to buy domestic goods, so export decreases and it becomes cheaper for home consumers to buy foreign goods, so import increases.

• If exchange rate increases from e1 to e2, then net export decreases from NX1 to NX2.

Net Capital Outflow and Exchange Rate

• NCO is independent of exchange rate because exchange rate is a stochastic variable.

• Factors affecting NCO include interest rates (domestic and foreign), risk of foreign investment, and government policies.

• The NCO curve with respect to exchange rate is vertical.

Combined NCO and NX Diagram

• Combining the downward-sloping NX curve and the vertical NCO curve determines the equilibrium exchange rate.

• The intersection of NX and NCO curves gives the equilibrium point and equilibrium exchange rate.

Government Budget Deficit: Effect on Net Export and Exchange Rate

Additional Scenario

How does a government budget deficit affect net export and exchange rate?

Recap

• Budget deficit leads to increased interest rates and decreased NCO.

Effect on NX and Exchange Rate

• With a balanced budget: NX1 and NCO1, equilibrium at F, exchange rate at E1.

• Due to budget deficit, NCO decreases, and the NCO curve shifts to the left.

• Equilibrium moves from F to G, and exchange rate increases from e1 to e2.

Given the increase in exchange rate, export decreases and import increases, which decreases net export.

US Trade Deficit and Government Budget Deficit

• The U.S. has a trade deficit (negative net export).

• A government budget deficit can contribute to a trade deficit because a budget deficit will cause the net export to be negative.

• Empirical observation: When the budget deficit is increasing, net export becomes more negative.

Fixed vs. Flexible Exchange Rate

• Fixed exchange rate: The central bank fixes the exchange rate.

• Flexible exchange rate: The exchange rate fluctuate every minute.

• In a fixed exchange rate system, the exchange rate does not change daily.

Example: Mexican Peso

• The Mexican peso was formerly fixed to the U.S. dollar.

• Disadvantages of fixed exchange rates include the risk of currency crash.

• In 1994, the Mexican peso experienced a currency crash where its value suddenly decreased significantly. The same has happened to the South Korean currency, Thailand and Indonesian currency.

• Currency crashes are more likely in fixed exchange rate systems, and I will explain those next class.