Instructor : Dr. Andrea Venegoni ( course responsible ) Mail: avenegoni@liuc.it

1. Economics II – Part 2November-December 2018Bachelor in Business Administration and Management Instructor: Dr. Andrea Venegoni (courseresponsible) Mail: avenegoni@liuc.it Office hours: Thursday, 3 p.m. (mail communicationrequired)

2. Second mid-term and exam Lectures’ Schedule • Thursday, 20/12 9.00 (c218) • 13/11 9.00-12.00 (c003) • 15/11 9.00-12.00 (c003) • 20/11 9.00-12.00 (c003) • 22/11 9.00-12.00 (c003) • 27/11 9.00-12.00 (c003) • 29/11 9.00-12.00 (c003) • 04/12 9.00-12.00 (c003) • 11/12 9.00-12.00 (c003) • 13/12 9.00-12.00 (c003) • 18/12 9.00-12.00 (c003)

3. Syllabus Part II: Open economy, expectations and the long run • Topic 1. The open economy (1), (Blanchard, Ch. 17, 18): Openness in goods and financial markets. • Topic 2. The open economy (2), (Blanchard, Ch. 18, 19): Openness in goods and financial markets (cont’d). • Topic 3. The open economy (3), (Blanchard, Ch. 20): The IS-LM model in open economy. • Topic 4. Expectations in Economics (1), (Blanchard, Ch. 14, 15, 16): Expectations in the Short Run and in the Medium Run. • Topic 5. Expectations in Economics (2), (Blanchard, Ch. 17): Expectations in the IS-LM model. • Topic 6. The Long Run (1), (Blanchard, Ch. 10, 11): The Growth Model. • Topic 7. The Long Run (2), (Blanchard, Ch. 11): The Growth Model (cont’d). • Topic 8. The Long Run (3), (Blanchard, Ch. 12): Technological progress and growth.

4. A brief recap of the milestones…….

5. Wherewe are and what’snext

6. The open economy: the basics, the goods’ market functioning and the Marshall-Lerner condition • Requiredreadings: Blanchard, O.J., Macroeconomics: an Europeanperspective (ch.18-19) • Suggestedreadings: • Whatisglobalization? (https://piie.com/microsites/globalization/what-is-globalization.html) • The future of global trade (https://www.ft.com/reports/future-of-global-trade) • Dangers from a trade war (https://www.ft.com/content/bc651dc2-88ef-11e8-b18d-0181731a0340) • The future treaths to international trade (https://www.imf.org/en/Publications/WEO/Issues/2018/09/24/world-economic-outlook-october-2018#Chapter%203) Chapter 1, trade tensionparagraph, pages 2-4. • The risks of globalization (https://www.gc.cuny.edu/CUNY_GC/media/LISCenter/pkrugman/PK_globalization.pdf)

7. Economicopennesat a glance Data are taken from World Bank database: https://data.worldbank.org/indicator/NE.EXP.GNFS.ZS?end=2017

8. Openness: whatdoesitmeaneconomically? Itsubstantiates in 3 ways: • Openness in goods market: the possibility for individuals and firms to choosebetweendomestic and foreigngoods. Thischoiceisnever free from restrictions, in allcountriesthere are some tariffs and quotasthathinder the free movement of goodsacrossborders. The trend in the last years (atleastuntil Trump…) sawtheserestrictionsdecreasing. • Openness in financialmarkets: capital marketshaveopenedsignificantly in the last 30 years. Investment in foreignassets and companies havebecome routine, eased by the abolition of restrictions on foreignassetsholdings (capital controls) • Openness in factormarkets: relocation & brain drain, i.e. the ability for firms to choosewhere to locate productiveplants and the possibility for workers to choose in which country to work. Bothphenomena display increasing trends.

9. Exchange rates Exchange rate (E): the price of a currencyexpressed in terms of another. For example the Euro/U.S.Dollarexchange rate has to be interpretedashowmanyDollarshave I to spend to buy 1 Euro. According to the ratesreported in the Table, to buy 1 Euro I need to spend 1.138 USDs, thatis 1 Euro isworth 1.138 USDs.

10. Nominal vs. Real Exchange rates

11. Real exchange rate: composition an meaning Nominalexchange rate The price of domesticgoods in terms of foreigngoods. ε= • In order to understandwhichis the domesticprice of a good relative to itsprice in a foreign country wehave first to express it in the foreigncurrency, passing from P to E∙P. • Then, beingnowall the pricesexpressed in the samecurrency (the foreign one), we can divide E∙P by P*, thatis the price of the goods in the foreign country expressed in the foreigncurrency Price of the good in the domestic country expressed in the domesticcurrency Price of the good in the foreign country expressed in the foreigncurrency

12. Real exchange rate: how to measureit To measure the realexchange rate priceindices of allgoodsproduced in the country are used. (i.e: GDP deflator, remember?). Problem: beingdeflators, by definition, indexnumbers, theirlevelit’sarbitrary and, hence, uninformative. Luckily, we are notinterested in levelsbut in the change of realexchangerates, thatstillremain informative. A 10% increase in the realexchange rate between the Euro Area and the U.S. meansthat Euro Area goodshavebecome 10% more expensivethan U.S. goods.

13. The goods market in the open economy Exports, imports and the trade balance. The moderneconomieshavebecome more and more interconnected in due course. Theirincreasedinterconnectedeness in goods and services trade is part of the process of the so-called «globalization». Exports (X): value of the domesticgoods and servicessold to foreign consumers Imports (IM): value of the foreigngoods and servicesconsumed by domestic consumers Trade balance (NX): differencebetweenexports and imports (NX=X-IM) Ifexportsexceedimports (NX>0), wehave a trade surplus. Ifimportsexceedexports (NX<0), wehave a trade deficit.

14. The financial market in the open economy • Open financialmarketsallowinvestors to choosewhether to holddomestic or foreignassets, diversifyingtheirportfolios and allowingthem to speculate on interest and exchangeratesmovements. • International financialtransactionsimplycurrencyexchange: anytimesomeonebuys a foreign asset implicitlybuysforeigncurrency • Openness in financialmarketsiscrucial for a country’s balance sheet: itallows to run a trade deficit, importing more thanitexports. To «cover» the difference, the country must borrow money from abroad, makingitattractive for investors to buydomesticassets.

15. National accounting: the Balance of Payments (bp) • International Accounting: in considering an economy open to the exchange of goods, services and capital with foreign countries, it is necessary to introduce the concepts related to the main items of the international budget of a nation. The balance of payments is balance sheet that refers to the reporting of transactions, both real and financial, with foreign entities. Capital Account: records the transactions of financial assets that took place between a country and the rest of the world. Balance of payments (bp): It can be understood as the total budget, i.e. the set of accounts that describe the transactions that occurred with the rest of the world in a given period of time. Trade Balance: It is given by the difference between exports, which produce an incoming cash flow, and imports, which produce an outgoing cash flow. NX = X-IM, To sum up, therefore, we can say that the balance of payments has two components, the first in which are listed the real transactions occurred with foreign countries in a given period of time (trade balance), the second in which the financial transactions are recorded, in entry and exit, made with foreign counterparty (Capital account).

16. Closed vs. Open Economy Keyfactor: the Real exchange rate level!

17. The goods market in open economy Introducing in our framework the «openness» feature, wehave to divide the demand in twocomponents: • Demand for domesticgoods (ZZ): the overall demand for goodsproduced in the country (domestic+foreign demand). • Domestic demand for domesticgoods (AA): considersonly the internal demand for domesticgoods.

18. Describinggoods’ market functioning in open economy (1/3): let’s start from whereweleft • Domestic Demand (DD): the totaldomestic demand for goods: C+I+G • Consumption, as in the standard model: • Investment, as in the standard model: I=f(Y,r) • Governmentexpenditure, as in the standard model: - +

19. Describinggoods’ market functioning in open economy (2/3): from domestic demand to domestic demand of domesticgoods • In order to pass from totaldomestic demand (DD) to the domestic demand of domesticgoods (AA) wehave to discard the part of domestic demand thatfalls to foreigngoods. We can do so by subtracting to the «DD» the imports: ; • Imports(IM)= Importsdepend on domesticincome (Y) and on the realexchange rate. Higher the income, higher the demand for goods, bothdomestic and foreign; higher the relative price of domesticgoodscompared to foreigngoods (higher the realexchange rate, ε) higherwill be the imports. IM=f(Y, ε) • BEWARE: we do not include the imports alone, butimportsrescaled by the realexchange rate. Thisisbecausedomestic and foreigngoods are different and in order to subtract the correctvalue of the goodsimportedthey must be expressed in terms of domesticgoods’ price. So measures the imports in terms of domesticgoods. + +

20. Describinggoods’ market functioning in open economy (2/3): the total demand for domesticgoods (Z) • In order to consider the overall demand for goodsproduced in a given country wehave to add to the domestic demand for domesticgoods an additional component: the exports. Indeed, the exportsrepresent the amount of domesticgoodsdemanded from abroad. • Exports (X). They are determined by the foreignincomelevel ( and the realexchange rate (ε). The higherthe higherwill be the foreign demand for domesticgoods, so the exports. Contrarily, the higher the relative price of domesticgoodscompared to foreignones (ε), the lowerwill be the foreign demand for domesticgoods and hence the exports. X=f( ε) - +

21. Let’sdraw some curves…. From DD to AA DD DD Domestic Demand (C+I+G) Domestic Demand (C+I+G) Demand,z Demand,z AA Domestic Demand for DomesticGoods (C+I+G- ) Output, Y Output, Y The question: why DD and AA have a differentslope? Precisely, why DD issteeperthan AA? ANSWER: Becauseasdomesticincome (Y) increases, some of the additional demand falls on foreign products, makingimportsincrease and than «pushing» down the domestic demand for domesticgoods.

22. Let’sdraw some curves…. From AA to ZZ DD DD Domestic Demand (C+I+G) Domestic Demand (C+I+G) Demand,z Demand,z Total Demand for DomesticGoods (C+I+G- +X) ZZ AA AA Domestic Demand for DomesticGoods (C+I+G- ) Domestic Demand for DomesticGoods (C+I+G- ) Output, Y Output, Y

23. The goods market equilibrium • As in the case for closedeconomies, the goods market is in equilibriumwhen the output (Y) isequal to the demand for domesticgoods. In otherwordswereach the equilibriumwhen the economy producesasmuchgoodsas the consumers (bothnational and international) demand. Y=ZZ • So, substituting ZZ for itsexpressionweobtain: Demand,z Total Demand for DomesticGoods (C+I+G- +X) ZZ Output, Y Y 45°

24. The goods market equilibrium and trade balance Demand,z Total Demand for DomesticGoods (C+I+G- +X) Thisis a particular case, in which the equilibrium in the goods market corresponds to a budget balance. Let’sseewhenthishappens…. ZZ Trade surplus Output, Y Net exports (NX) Output, Y Trade deficit 45°

25. The goods market equilibrium and trade balance If ZZ and DD do not cross where Y=ZZ If ZZ and DD cross where Y=ZZ DD Demand,z Demand,z DD ZZ ZZ Y Trade surplus Trade surplus Output, Y Output, Y Net exports (NX) Net exports (NX) Output, Y Output, Y Y Trade deficit Trade deficit 45° 45°

26. Whathappensifdomestic demand changes? DD’ Let’s suppose the governmentincreases the public expenditure G (G↑) . Whathappens to the goods market equilibrium? An increase in G, makesboth DD and ZZ shift upwards. The NX curve doesnotchange, as G doesnotdirectlyaffectboth IM and X. Thisupward shift, of the sameamount, doesnot alter the production levelthatdetermines the equilibrium in the trade balance (where DD’ crosses ZZ’), while the equilibrium in the goods market (the point in which ZZ and the axisbisector cross) shiftsrightwards. Summing up, an increase in G, leads to an increase in the equilibrium output (Y). This rise in Y makes demand of importedgoodsaugment, leavingexportsunchanged, and hencedeteriorating the trade balance thatnowregisters a deficit DD Demand,z Demand,z DD ZZ’ ZZ ZZ Output, Y Output, Y Y Y Net exports (NX) Net exports (NX) Output, Y Output, Y Trade deficit 45° 45°

27. Whathappensifforeign demand changes? (analyticexplanation) • Now, let’s figure out that, instead of the nationalgovernment, the foreign one increases the public expenditure? Whathappens to the nationalgoods market equilibrium and trade balance? • If G*↑ZZ* ↑and so Y *↑. • Does an increase in Y* affect the domesticgoods market? • The answeris YES!! • How? • By increasingdomesticexports (recallthat X=f(Y*,ε)) so an increase in Y* makes X increase, movingboth the ZZ (not the DD) and the NX curves.

28. Whathappensifforeign demand changes? (graphicalexplanation) Let’s suppose the foreigngovernmentincreases the public expenditure G* (G * ↑) . Whathappens to the domesticgoods market equilibrium? If G*↑ZZ* ↑and so Y *↑ If Y *↑ X ↑NX ↑ (NX curve shiftsrightwards) If NX ↑ZZ ↑ Y↑ Wehave a new equilibrium in the goods market associated with a higher ZZ and Y. Differently from the case of an increase in domestic demand, herewe do nothave a deterioration of the trade balance, but, wehave a trade surplus. Demand,z Demand,z DD DD ZZ’ ZZ ZZ Output, Y Output, Y Net exports (NX) Net exports (NX) Output, Y Output, Y Y NX NX’ NX 45° 45°

29. Implications for fiscal policy in an open world Whatwehave just sawstimulatestwokind of observations: • Demand shocks in one country propagates to the others. (Financial and sovereigndebtcrisesprovedthis) • Differently from fiscal policy in a closed economy, in the open economy itis more «costly», as a fiscal stimulusimplies a deterioration of the trade balance and, hence, increasedindebtednesstowards the rest of the world

30. Modifications of the exchange rate: what do theyimply? (1/2) • What happensif a governmentdecides to modify the value of itscurrency (it can do so by means of monetary policy actions, wewillseeitlater on..)? • Let’s suppose the governementchooses to depreciateitscurrency, thatislowering the nominalexchange rate. If the nominalexchange rate (E) decreases, we assume that the real one εdecreases in the same way (prices are consideredfixed in the short run). • So, how a decrease in εaffects the domesticgoods market equilibrium? ε=

31. Modifications of the exchange rate: what do theyimply? (2/2) • So, ifε↓: • X↑, asthey are inverselyrelated to . Lower the cost of domesticgoods relative to that of foreigngoods, higherwill be the propensity of foreigners to by ourgoods and so exportswill go up. • IM↓, for the inverse reasoningperformed for exports. Lower realexchangeratesmeanthatbuyforeigngoodsis more costly, hencepeopledecreasetheir demand on importedgoods. • 1/ εincreases. This, for a givenquantity of imports, raisestheir cost, making the samequantity of imports more costly to buy. • Summing up: for a realdepreciation to improve the trade balance (↑) the increase in exports and the decrease in imports must offset the increase in the price of importedgoods.

32. Marshall-Lerner condition and the J-curve For a realdepreciation to increase Net Exports (NX) it must holdthat the increase in exports and decrease in importsgenerated by the lowerε must offset the increase in the relative price of domesticgoodscompared to foreignones. The Marshall-Lerner conditionsaysthat a realdepreciationleads to an increase in net exports. Nevertheless, thisdoesnothappenimmediately. In the very short term, the priceeffectisbound to prevail on quantityeffects, leading net exports to decrease. Slowly, the exports and importsquantity are bound to adapt, and the quantityeffectwill more than offset the price one, leading to an increase in NX. Simulation on UnitedStatesquarterly data (1970-2018), taken from the FRED database (Federal reservebank of Saint Louis db). Response of Net Exports and Consumption to a 1 standard deviationdecrease in the realexchange rate