Economics 154a Open-Economy Macroeconomics

1. Topics: 1. Balance of payments accounting 2. Saving and investment in the open economy 3. Determination of the exchange rate Economics 154a Open-Economy Macroeconomics

2. Essential balancing property of Balance of Payments Current AccountA Financial Account -A Net Balance 0

3. Balance of Payments v. Real Goods and Services • Macro: NX = Net Exports = exports goods and services – imports g&s 2. Current account: Current account = NX + locational adjustments (domestic v. national product) + unilateral transfers (not current goods/services) Difference = locational stuff + transfers

5. Openness/globalization: Trade Rising trend

6. Savings and Investment in the Open Economy ACCOUNTING: Y = output = C + I + G + NX Y = income = Yd + T + Sb = C + Spers + Sb + T = C + Spriv+ T → I + NX = Spriv + Sgov = Sn or NX = Spriv + Sgov – I = Sn – I FINANCIAL COUNTERPART: Net domestic saving = net foreign investment = lending abroad = ΔNFA = financial account deficit that corresponds to the current account surplus

7. Overview of analysis • Savings-investment accounting • S, I, and NX determination • How S, I, and NX determine real exchange rate • Small and large open economies

8. Classical Open Economy Equilibrium Now study open-economy equilibrium: 1. Classical economy (full employment, flex w and p); this implies that domestic output is at potential 2. Small open economy • Too small to affect goods prices or financial markets 3. Mobile financial capital • free flow of funds among countries • Investors therefore compare domestic and foreign interest rates (rd, rw ) • In small economy, rd = rw = world interest rate

9. Recall Closed Economy S and I equilibrium Real interest rate (r) Sn = Spriv + (T-G) r* Id (r) S, I I*

10. Open Economy S and I equilibrium Real interest rate (r) Sn = Spriv + (T-G) Net exports > 0 r*=rW China today; OPEC countries Id (r) S, I I*

11. Open Economy S and I equilibrium Real interest rate (r) Sn = Spriv + (T-G) US today; LDCs classically rW Net exports < 0 Id (r) S, I I*

12. Shock I: Increase in world interest rate Real interest rate (r) S = Sp + (T-G) rW’ NX** rW NX* Id (r) S, I I** I*

13. Shock II: Increase in G Real interest rate (r) S* S** NX*>0 rW NX**<0 Id (r) S, I I*

14. “International money”:Foreign exchange rates

15. Financial Globalization

16. Exchange rates Foreign-exchange rates are the relative prices of different national monies or currencies. Convention in Econ 154: Nominal exchange rate • exchange rates = amount of foreign currency per unit of domestic currency. • Think Japanese Yen: 100 yen to $.

17. Terminology For market-determined exchange rates: • An appreciation of a currency is when the value of the currency rises • e or R rises • A depreciation of a currency is when the value of the currency falls • e or R falls For fixed exchange rates: • Price set by government is the “parity.” • A revaluation is an increase in the official parity. • A devaluation is a decrease in the parity.

18. Index of US nominal exchange rate (e) Appreciation Depreciation

19. Political crisis and a domestic risk premium • Question for reflection in class: • Assume that there is a political crisis in Slobovia. • Investors now require a risk premium for investing there (relative to the rest of the world • What happens? • Domestic interest rate rises above world rate by risk premium (δ). • This is similar to rise in world interest rate.

20. ?

21. Shock III: Domestic financial disturbance Real interest rate (r) S = Sp + (T-G) rd = rW + risk premium NX** rW NX* Id (rd) S, I I** I*

22. The Transmission Mechanism in Open Economy Macro We saw that changes in domestic saving and investment, or changes in world interest rates, or domestic risk premiums would affect net exports. How does that happen? Through the adjustment of the real exchange rate. Let see how.

23. Real exchange rates Real exchange rate, R [Mankiw uses ε) R = nominal exchange rate corrected for relative prices R = e × (p d / p f ) = p d / (p f / e) = domestic prices/foreign prices in a common currency Note: If you calculate the rate of growth of R, you get

24. Real exchange rate of $ relative to major currencies (R) Appreciation Depreciation

25. We are now looking for equilibrium: NX(R) = Spriv + Sg – I(rw) The only new relationship is NX(R): • Real deprecation (R ↓) lowers the price of exports in foreign markets and raises import P in domestic markets. • This raises exports and lowers imports; raising NX. • Hence NX’(R) < 0 ……………………….. Using the NX curve and S-I curves, we can see how real exchange rate is determined.

26. Net exports and the real exchange rate Real exchange rate (R) Why is NX so negative for US? R* NX(R) NX* 0 NX

27. Savings-investmen and the determination of the real exchange rate: NX(R) = Sn-I(rw) Have two behavioral relationships: (1) NX and (2) net savings. R is determined where those two equilibrate savings and investment. Sn-I(rw) R R* E* NX(R) S-I, NX NX* 0

28. Fiscal tightening

29. Fiscal tightening Fiscal policy:G ↓ →net S ↑ → R ↓ →NX ↑ (S-I(rw))* (S-I(rw))** R E* E** NX(R) S-I, NX NX* 0 NX**

30. Impact of protectionism

31. Protectionism (S-I(rw)) R R** R* NX(R)’ NX(R) S-I, NX NX*=NX** 0

32. Now analyze large open economy

33. Now analyze large open economy Large Open Economy: - Country large enough to affect world financial markets - Domestic assets imperfect substitutes for foreign assets. - Key assumption that domestic r differs from foreign r (rd ≠ rw) Analysis Goods markets: • NX(R) = Sn– I(rd) Financial market equilibrium: CF = net financial investment abroad = - financial surplus (2) CF = CF(rd, rw). In analysis, we suppress rw Notes that capital flows in if domestic interest rates rise CF’(rd) < 0. Equilibrium comes when (1) and (2) equilibrate: (3) NX(R) = CF(rd) = Sn– I(rd) In our diagrams below, we reorganize and use: (4) I(rd) + CF(rd) = Spriv + Sg = S

34. Domestic interest rate (rd) rd CF(rd) CF* 0 CF

35. Domestic interest rate (rd) rd S rd* I+CF CF(rd) CF* CF 0 S, I,CF Real exchange rate, R R* NX(R) NX CF NX* 0 CF

36. Bernanke’s theory of why the US deficit is so high

37. Domestic interest rate (rd) rd S rd* CF(rd) I+CF CF 0 S, I,CF R • Bernanke’s “world savings glut” • Current situation is one in which rest of world has savings glut (particularly China and oil exporting countries accumulating $ reserves). • This increases inflows to US. • This is leading to low world and US real interest rates and to the large US trade deficit. R* NX(R) NX CF NX* 0 CF