Macroeconomic Theory of the Open Economy

Key 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 corrected?

• How do government budget deficits affect the exchange rate and trade balance?

Recap of CH13: Market for Loanable Funds

• Supply: National Saving S = Y - C - G

• Demand: Investment

• Closed Economy

  • Fiscal Policy:

    • Expansionary: G
      ightharpoonup or T
      ightharpoonup (
      ightharpoonup represents increase)

    • Contractionary: G
      ightharpoonup or T
      ightharpoonup (
      ightharpoonup represents decrease)

  • Gov provides tax incentives to encourage Investment (I)

    • Demand for borrowing increases.

  • Expansionary Fiscal Policy -> G
    ightharpoonup or T
    ightharpoonup

  • Contractionary Fiscal Policy -> G
    ightharpoonup or T
    ightharpoonup => slow down an overheating or curb inflation

CH18

• Y = C + I + G + NX

• Y - C - G = I + NX

• S = I + NX

• Open Economy! NX = NCO

• S = I + NCO

• S & I depends on i (interest rate)

• Net Capital Outflow (NCO) = Domestic residents buy foreign financial assets - Foreign residents buy domestic financial assets.

• Real interest rate is the real return on the domestic assets.

• "Imagine" "High interest rate"

  • Domestic assets become more attractive.

  • Real interest rate decreases.

  • People in the US buy less foreign financial assets.

  • People abroad buy more US financial assets.

  • NCO decreases.

Active Learning: Budget Deficit

• Suppose the government runs a budget deficit.

• Determine the effects on the real interest rate & NCO.

• Budget Deficit: G \uparrow => S = Y - C - G \downarrow

  • Loanable Funds (LF) market

    • Supply decreases.

    • Interest rate increases.

    • NCO decreases.

• Keep in Mind: LF markets determine the real interest rates (i). The value of i determines the NCO.

The Market for Foreign-Currency Exchange

• Price? Real Exchange Rate (R).

• R = \frac{P}{P}, where P is domestic price and P is foreign price.

• Key determinants of NX.

• Demand for $ is decided by NX.

• Supply of $ is decided by NCO.

• US exports increase (EX \uparrow) -> US NX \uparrow -> Demand for $ increases.

• US Imports increase (IMP \uparrow) -> US NX \downarrow

• Foreigners invest in US -> NCO decreases -> Supply of $ decreases.

Changes in the market for L in open economy?

• S = I + NCO

• S \downarrow -> open economy?

• I \downarrow -> open economy?

Active Learning: Budget Deficit & Trade Balance

• S \downarrow -> i \uparrow -> NCO \downarrow

• Loanable Funds market -> i \uparrow -> NCO \downarrow

• NCO decreases -> Supply of $ in foreign exchange market decreases -> Real Exchange Rate (R) appreciates.

• Budget Deficit reduces NCO -> R appreciates -> NX \downarrow

• Since Trade used to be a balance, the Budget Deficit causes a trade deficit (NX < 0).

Active Learning 2: Investment Incentives

• Suppose the Government provides new tax incentives to encourage investment.

• Demand increases -> i \uparrow -> NCO decreases.

• Budget Deficit & Incentives on I: Both increase the real interest rates -> R appreciates -> NX decreases.

Important Difference

• Investment Incentives -> I \uparrow -> K \uparrow -> E \uparrow (living standards increase).

• Budget Deficit -> I \downarrow -> Productivity decreases (Living standards decrease).

Changes in the Currency Market

• A government policy that directly influences the quantity of goods that a country exports or imports => "Trade Policy".

  • ex) Tariff - a tax on imported goods & services.

  • Quota - a limit on the quantity of imports.

Analysis of Quota on Cars from Japan

• Quota does NOT affect S or I, it does NOT change NCO -> No change in the real interest rate.

• NX = EX - IM, Exports increase, Imports decrease

• Demand increases, Demand for $ increases.

Surprising Implications

• Quota => $ appreciates -> decreases (Japan Auto makers). US aircraft increases

• US NX on cars increases, US NX on aircraft decreases. Overall trade balance stays the same!

• Trade policy do not affect trade balance because they do not affect S & I.

• However, it still affects firms & industries.

• Quota -> US car Demand increases -> US car hire increases.

• It reduces the workers in the aircraft industry

• In general, it destroys jobs in the US EX industry.