A

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.