CH 32 A Macroeconomic Theory of The Open Economy

N.
GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eighth Edition
CHAPTER
A Macroeconomic Theory
32 of the Open Economy
Premium PowerPoint Slides by:
V. Andreea CHIRITESCU
Eastern Illinois University
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning
1
management system for classroom use.
Look for the answers to these 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 connected?
• How do government budget deficits affect
the exchange rate and trade balance?
• How do other policies or events affect the
interest rate, exchange rate, and trade
balance?
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 2
Introduction
• Previous chapter: basic concepts and
vocabulary of the open economy:
– Net exports (NX)
– Net capital outflow (NCO)
– Exchange rates
• This chapter: theory of the open economy
– See how government policies and various
events affect the trade balance, exchange
rate, and capital flows
Market for Loanable Funds
• In an open economy, S = I + NCO
Saving = Domestic investment + Net capital
outflow
• Supply of loanable funds
– From national saving (S)
• Demand for loanable funds
– From domestic investment (I)
– And net capital outflow (NCO)
Market for Loanable Funds
• When NCO > 0, net outflow of capital
– Net purchase of capital overseas
• Adds to the demand for domestically
generated loanable funds
• When NCO < 0, net inflow of capital
– Capital resources coming from abroad
• Reduce the demand for domestically
generated loanable funds
How NCO Depends on the Real Interest Rate
The real interest rate, r, is
the real return on domestic Net capital outflow
r
assets.
A fall in r makes domestic
assets less attractive r1
relative to foreign assets. r2
People in the U.S.
purchase more foreign NCO
assets.
NCO
People abroad purchase NCO1 NCO2
fewer U.S. assets.
NCO rises.
The Loanable Funds Market Diagram
Loanable funds
r Both I and NCO
S = saving depend negatively on
r, so the D curve is
downward-sloping.
r1
r adjusts to balance
D = I + NCO supply and demand in
the LF market.
LF
Active Learning 1
Budget deficits and capital flows
Suppose the government runs a budget deficit
(previously, the budget was balanced).
Use the appropriate diagrams to determine
the effects on the real interest rate and net
capital outflow.
Active Learning 1 Answers
A
The When
budget
higher rworking
deficit
makes withsaving
reduces
U.S. this
bondsmodel,
and
more keep
the in mind:
attractive
supply of
relative
LF,
causingthe
to foreign LFrise.
r to market
bonds, determines
reduces NCO. r (in left graph),
then this value of r determines NCO (in right graph).
Loanable funds Net capital outflow
r r
S2
S1
r2 r2
r1 r1
D1 NCO1
LF NCO
Foreign-Currency Exchange
• The market for foreign-currency exchange
– Identity: NCO = NX
– Net capital outflow = Net exports
– NX is the demand for dollars:
• Foreigners need dollars to buy U.S. net
exports.
– NCO is the supply of dollars:
• U.S. residents sell dollars to obtain the
foreign currency they need to buy foreign
assets.
Foreign-Currency Exchange
• The U.S. real exchange rate (E)
– Measures the quantity of foreign goods &
services that trade for one unit of U.S.
goods & services.
– E is the real value of a dollar in the market
for foreign-currency exchange.
The Market for Foreign-Currency Exchange
An increase in E makes U.S.

goods more expensive to E S = NCO
foreigners, reduces foreign
demand for U.S. goods—and
U.S. dollars.
E1
An increase in E has no
effect on saving or
investment, so it does not D = NX
affect NCO or the supply of
dollars.
Dollars
E adjusts to balance supply
and demand for dollars in the
market for foreign- currency
exchange.
FYI: Disentangling Supply and Demand
When a U.S. resident buys imported goods, does
the transaction affect supply or demand in the
foreign exchange market? Two views:
1. The supply of dollars increases. The person
needs to sell her dollars to obtain the foreign
currency she needs to buy the imports.
2. The demand for dollars decreases. The increase
in imports reduces NX, which we think of as the
demand for dollars.
(So, NX is really the net demand for dollars.)
• Both views are equivalent. For our purposes,
it’s more convenient to use the second.
FYI: Disentangling Supply and Demand
When a foreigner buys a U.S. asset, does the
transaction affect supply or demand in the foreign
exchange market? Two views:
1. The demand for dollars increases. The foreigner
needs dollars in order to purchase the U.S.
asset.
2. The supply of dollars falls. The transaction
reduces NCO, which we think of as the supply of
dollars.
(So, NCO is really the net supply of dollars.)
• Again, both views are equivalent. We will use the
second.
Active Learning 2
Budget deficit, exchange rate, NX
• Initially, the government budget is balanced
and trade is balanced (NX = 0).
• Suppose the government runs a budget
deficit. As we saw earlier, r rises and NCO
falls.
• How does the budget deficit affect the U.S.
real exchange rate? The balance of trade?
Market for foreign-
The budget deficit currency exchange
reduces NCO and the S2 = NCO2
supply of dollars. E S1 = NCO1
The real exchange
rate appreciates, E2
reducing net exports.
E1
Since NX = 0 initially,
the budget deficit
causes a trade deficit D = NX
(NX < 0).
Dollars
The “Twin Deficits” Net exports and the budget deficit
6.00%
often move in opposite directions.
U.S. federal
budget deficit
4.00%
Percent of GDP
2.00%
0.00%
-2.00%
U.S. net exports
-4.00%
-6.00%
1961- 1966- 1971- 1976- 1981- 1986- 1991- 1996- 2001- 2006- 2011-
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
SUMMARY
• The effects of a budget deficit
– National saving falls.
– The real interest rate rises.
– Domestic investment and net capital
outflow both fall.
– The real exchange rate appreciates.
– Net exports fall (or, the trade deficit
increases).
SUMMARY
• One other effect:
– As foreigners acquire more domestic assets, the
country’s debt to the rest of the world increases.
Due to many years of budget and trade deficits, the U.S. is
now the “world’s largest debtor nation.”
International Investment Position of the U.S.
30 June 2016
Value of U.S.-owned foreign assets $31.6 trillion
Value of foreign-owned U.S. assets $24.1 trillion
U.S.’ net debt to the rest of the world $ 7.5 trillion
The Connection Between Interest Rates and
r
Exchange Rates
Anything that increases r r2
will reduce NCO
r1
and the supply of dollars in the
foreign exchange market. NCO
Result: The real exchange rate NCO
appreciates. NCO1
NCO2
Keep in mind: The LF market (not
E
shown) determines r. S2 S1 = NCO1
This value of r then determines
NCO (shown in upper graph). E2
This value of NCO then E1
determines supply of dollars in D = NX
foreign exchange market (in lower
graph). dollars
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly NCO
accessible 2 NCO
website, in whole or 1 for use
in part, except
Active Learning 3 Investment incentives
Suppose the government provides new tax

incentives to encourage investment.
Use the appropriate diagrams to determine how
this policy would affect:
• the real interest rate
• net capital outflow
• the real exchange rate
• net exports
Investment—and the demand for LF—increase at each

value of r. r rises, causing NCO to fall.
r r
S1
r2 r2
r1 r1
D2
D1 NCO
LF NCO
NCO2 NCO1
The fall in NCO Market for foreign-
reduces the currency exchange
supply of dollars S2 = NCO2
in the foreign
E S1 = NCO1
exchange market.
E2
The real exchange
rate appreciates, E1
reducing net
exports D = NX
Dollars
Budget Deficit
vs. Investment Incentives
• A tax incentive for investment has similar
effects as a budget deficit:
– r rises, NCO falls
– E rises, NX falls
• But one important difference:
– Investment tax incentive increases investment,
which increases productivity growth and living
standards in the long run.
– Budget deficit reduces investment, which
reduces productivity growth and living standards.
Trade Policy
• Trade policy:
– Government policy that directly influences
the quantity of goods and services a
country imports or exports
– Tariff – a tax on imports
– Import quota – a limit on the quantity of imports
– “Voluntary export restrictions” – the government
pressures another country to restrict its exports
(essentially the same as an import quota)
Trade Policy
• Common reasons for policies that restrict
imports:
– Save jobs in a domestic industry that has
difficulty competing with imports
– Reduce the trade deficit
• Do such trade policies accomplish these
goals?
Analysis of a Quota on Cars from Japan
An import quota does not affect saving or investment,

so it does not affect NCO. (Recall: NCO = S – I.)

r r
S
r1 r1
D NCO
LF NCO
Since NCO is unchanged, Market for foreign-

currency exchange
S curve does not shift.
The D curve shifts: E S = NCO
At each E,
imports of cars fall, E2
so net exports rise,
D shifts to the right. E1
At E1, there is excess D2
demand in the foreign D1
exchange market.
Dollars
E rises to restore equilibrium.
• What happens to NX? Nothing!
– If E could remain at E1, NX would rise, and the
quantity of dollars demanded would rise.
– But the import quota does not affect NCO,
so the quantity of dollars supplied is fixed.
– Since NX must equal NCO, E must rise enough
to keep NX at its original level.
Hence, the policy of restricting imports does
not reduce the trade deficit.
Does the policy save jobs?
• The quota reduces imports of Japanese autos
– U.S. consumers buy more U.S. autos.
– U.S. automakers hire more workers to produce
these extra cars.
– So the policy saves jobs in the U.S. auto industry.
• But E rises, reducing foreign demand for U.S.
exports.
– Export industries contract, exporting firms lay off
workers.
The import quota saves jobs in the auto industry but
destroys jobs in U.S. export industries!!
Capital Flows from China
• In recent years, China has accumulated
U.S. assets:
– China’s foreign assets: from 2000 to 2012,
increased from $160 billion to $4 trillion
(including U.S. government bonds)
– To reduce its exchange rate and boost its
exports
• Results in U.S.:
– Appreciation of $ relative to Chinese renminbi
– Higher U.S. imports from China
– Larger U.S. trade deficit
Political Instability and Capital Flight
• 1994: Political instability in Mexico made
world financial markets nervous.
– People worried about the safety of
Mexican assets they owned
– People sold many of these assets, pulled
their capital out of Mexico
• Capital flight:
– Large and sudden reduction in the
demand for assets located in a country
Capital Flight from Mexico
As foreign investors sell their assets and pull out their capital,
NCO increases at each value of r.
Demand for LF = I + NCO. The increase in NCO increases
demand for LF.
The equilibrium values of r and NCO both increase.
r r
S1
r2 r2
r1 r1
D2 NCO2
D1 NCO1
LF NCO
Capital Flight from Mexico
Market for foreign-

The increase in NCO currency exchange
causes an increase in
E S1 = NCO1
the supply of pesos in
the foreign exchange S2 = NCO2
market.
The real exchange rate E1
value of the peso falls.
E2
D1
Pesos
Examples of Capital Flight: Mexico, 1994
0.35
US Dollars per currency unit .
0.30
0.25
0.20
0.15
0.10
10/23/1994
11/12/1994
12/2/1994
12/22/1994
1/11/1995
1/31/1995
2/20/1995
4/1/1995
3/12/1995
Examples of Capital Flight: S.E. Asia, 1997
120 South Korea Won

Thai Baht
US Dollars per currency unit.
100 Indonesia Rupiah
80
1/1/1997 = 100
60
40
20
0
12/1/1996
2/24/1997
5/20/1997
8/13/1997
11/6/1997
1/30/1998
4/25/1998
7/19/1998
Examples of Capital Flight: Russia, 1998
0.20
US Dollars per currency unit .
0.16
0.12
0.08
0.04
0.00
5/5/1998
9/2/1998
10/12/1998
11/21/1998
12/31/1998
6/14/1998
7/24/1998
Examples of Capital Flight: Argentina, 2002
1.2
U.S. Dollars per currency unit .
1.0
0.8
0.6
0.4
0.2
0.0
7/1/2001
12/8/2001
5/17/2002
8/5/2002
10/24/2002
9/19/2001
2/26/2002
1/12/2003
ASK THE EXPERTS
Currency Manipulation
“Economic analysis can identify whether
countries are using their exchange rates to
benefit their own people at the expense of
their trading partners’ welfare.”
Conclusion
• The U.S. economy is becoming
increasingly open:
– Trade in goods and services is rising
relative to GDP.
– Increasingly, people hold international
assets in their portfolios and firms finance
investment with foreign capital.
Conclusion
• Yet, we should be careful not to blame
our problems on the international
economy.
– Our trade deficit is not caused by other
countries’ “unfair” trade practices, but by
our own low saving.
– Stagnant living standards are not caused
by imports, but by low productivity growth.
Summary
• Two markets are central to the macroeconomics of
open economies:
• The market for loanable funds: the real interest
rate adjusts to balance the supply of loanable
funds (from S) and the demand for loanable
funds (for I and NCO).
• The market for foreign-currency exchange: the
real exchange rate adjusts to balance the supply
of dollars (from NCO) and the demand for dollars
(for NX).
• NCO - connects these two markets.
Summary
• A policy that reduces national saving, such as a
government budget deficit, reduces the supply of
loanable funds and drives up the interest rate.
• The higher interest rate reduces net capital
outflow, which reduces the supply of dollars in
the market for foreign-currency exchange.
• The dollar appreciates, and net exports fall.
• When investors change their attitudes about
holding assets of a country: political instability can
lead to capital flight, which tends to increase
interest rates and cause the currency to depreciate.
Summary
• A trade restriction increases net exports for any
given exchange rate and, therefore, increases the
demand for dollars in the market for foreign-
currency exchange.
• The dollar appreciates in value, making domestic
goods more expensive relative to foreign goods.
This appreciation offsets the initial impact of the
trade restriction on net exports.

CH 32 A Macroeconomic Theory of The Open Economy

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CH 32 A Macroeconomic Theory of The Open Economy

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N.

An increase in E makes U.S.

Suppose the government provides new tax

Investment—and the demand for LF—increase at each

An import quota does not affect saving or investment,

Loanable funds Net capital outflow

Since NCO is unchanged, Market for foreign-

Market for foreign-

120 South Korea Won

100 Indonesia Rupiah

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