Presentation on theme: "mankiw's macroeconomics modules"— Presentation transcript:
1 mankiw's macroeconomics modules A PowerPointTutorialto Accompany macroeconomics, 5th ed.N. Gregory MankiwMannig J. SimidianCHAPTER FIVEThe Open Economy
2 National Income Accounts Identity in an Open Economy Y = C + I + G + NXTotal demandfor domesticoutputis composedofInvestmentspending bybusinesses andhouseholdsGovernmentpurchases of goodsand servicesNet exportsor net foreigndemandConsumptionspending byhouseholdsNotice we’ve added net exports, NX, defined as EX-IM. Also, note that domestic spending on all goods and services is the sum of domestic spending on domestics goods and services and on foreign goods and services.
3 Y = C + I + G + NX NX = Y - (C + I + G) After some manipulation, the national income accounts identity can be re-written as:NX = Y - (C + I + G)Net ExportsDomesticSpendingOutputThis equation shows that in an open economy, domestic spending neednot equal the output of goods and services. If output exceeds domesticspending, we export the difference: net exports are positive. If outputfalls short of domestic spending, we import the difference: net exportsare negative.
4 Net Foreign Investment & the Trade Balance Start with the national income accounts identity. Y=C+I+G+NX.Subtract C and G from both sides and obtain Y-C-G = I+NX.Let’s call this S, national saving.So, now we have S=I+NX. Subtract I from both sides to obtain the newequation, S-I=NX.This form of the national income accounts identity shows that aneconomy’s net exports must always equal the difference between itssaving and its investment.S-I=NXTrade BalanceNet Foreign Investment
5 Net Capital Outflow = Trade Balance S-I=NXIf S-I and NX are positive, we have a trade surplus. We would be netlenders in world financial markets, and we are exporting moregoods than we are importing.If S-I and NX are negative, we have a trade deficit. We would be netborrowers in world financial markets, and we are importing moregoods than we are exporting.If S-I and NX are exactly zero, we have balanced trade since the valueof imports equals the value of exports.
6 Saving and Investment in a Small Open Economy We are now going to develop a model of the international flows of capital and goods. Then, we’ll address issues such as how the trade balance responds to changes in policy.
7 Capital Mobility and the World Interest Rate Recall that the trade balance equals the net capital outflow, whichin turn equals saving minus investment, our model focuses on savingand investment. We’ll borrow a part of the model from Chapter 3, butwon’t assume that the real interest rate equilibrates saving andinvestment. Instead, we’ll allow the economy to run a trade deficitand borrow from other countries, or to run a trade surplus and lendto other countries.Consider a small open economy with perfect capital mobility inwhich it takes the world interest rate r* as given, denoted r = r*.Remember in a closed economy, what determines the interest rate is theequilibrium of domestic saving and investment--and in a way, the worldis like a closed economy-- therefore the equilibrium of world saving andworld investment determines the world interest rate.
8 The Model The economy’s output Y is fixed by the Y = Y = F(K,L) factors of production and the productionfunction.Consumption is positively related todisposable income (Y-T).C = C (Y-T)Investment is negatively related to thereal interest rate.I = I (r)NX = (Y-C-G) - Ior NX = S - IThe national income accounts identity,expressed in terms of saving and investment.Now substitute our three assumptions from Chapter 3 and the conditionthat the interest rate equals the world interest rate, r*.NX = (Y-C(Y-T) - G) - I (r*)NX = S I (r*)This equation suggests that the trade balance is determined by thedifference between saving and investment at the world interest rate.
9 Saving and Investment in a Small Open Economy I(r)Investment, Saving, I, SRealinterestrate, r*rclosedIn a closed economy, r adjusts toequilibrate saving and investment.r*NXIn a small open economy, theinterest rate is set by worldfinancial markets. The differencebetween saving and investmentdetermines the trade balance.r*'NXIn this case, since r* is above rclosed and saving exceeds investment,there is a trade surplus.If the world interest rate decreased to r* ', I would exceed S andthere would be a trade deficit.
10 A Domestic Fiscal Expansion in a Small Open Economy An increase in government purchases or a cut in taxes decreases national saving and thus shifts the national saving schedule to the left.SI(r)Investment, Saving, I, SRealinterestrate, r*r*S'NX = (Y-C(Y-T) - G) - I (r*)NX = S I (r*)NXThe result is a reduction in nationalsaving which leads to a trade deficit,where I > S.
11 A Fiscal Expansion Abroad in a Small Open Economy A fiscal expansion in a foreign economy large enough to influence world saving and investment raises the world interest ratefrom r1* to r2*.SI(r)Investment, Saving, I, SRealinterestrate, r*r1*NXThe higher world interest rate reducesinvestment in this small openeconomy, causing a trade surpluswhere S > I.r2*
12 A Shift in the Investment Schedule in a Small Open Economy An outward shift in the investment schedule from I(r)1 to I(r)2 increases the amount of investment at the world interest rate r*.NXAs a result, investment nowexceeds saving I > S, whichmeans the economy isborrowing from abroad andrunning a trade deficit.SI(r)1Investment, Saving, I, SRealinterestrate, r*r1*I(r)2
13 Exchange Rates In the next few slides, we’ll learn about the foreign exchange market, exchange rates and much more!
14 The Mechanics of the Foreign Exchange Market Let’s think about when the US and Japan engage in trade. Each country has different cultures, languages, and currencies, all of which could hinder trade. But, because of the foreign exchange market, trade transactions become more efficient. The foreign exchange market is a global market in which banks are connected through high-tech telecommunications systems in order to purchase currencies for their customers.The next slide is a graphical representation of the flow of the trade between the U.S. and Japan, and how the mix of traded things might be different, but is always balanced. Also, notice how the foreign exchange market will play the middle-man in these transactions. For instance, the foreign exchange market converts the supply of dollars from the U.S. into the demand for yen, and conversely, the supply of yen into the demand for dollars.
15 Japan U.S. GOODS & SERVICES In order for the U.S to pay for its imports of goods and services and securities from Japan,The ForeignExchange Marketit must supply dollars which are then converted into yen by the foreign exchange market.& SecuritiesGOODS & SERVICESJapanU.S.DemandYENSupply$ForeignExchangeMarketSupplyYENDemand$Goods and Services &SECURITIESIn order for Japan to pay for its imports of goods and services and securities from the U.S.,it must supply yen which are then convertedinto dollars by the foreign exchange market.
16 Exchange Rates Nominal vs. real The exchange rate between two countries is the price at whichresidents of those countries trade with each other.
17 -relative price of the currency of two countries -denoted as e Nominal Exchange Rate-relative price of the goods of two countries-sometimes called the terms of trade-denoted as eReal Exchange Rate
18 Nominal Exchange Rate, e The nominal exchange rate is the relative price of the currency oftwo countries. For example, if the exchange rate between the U.S.dollar and the Japanese yen is 120 yen per dollar, then you canexchange 1 dollar for 120 yen in world markets for foreign currency.A Japanese who wants to obtain dollars would pay 120 yen for eachdollar he bought. An American who wants to obtain yen would get120 yen for each dollar he paid. When people refer to “the exchangerate” between two countries, they usually mean the nominal exchangerate.
19 Appreciation and Depreciation Suppose that there is an increase in the demand for U.S. goods andservices. How will this affect the nominal exchange rate?eDollar Value of TransactionsD$Ae0S$$D$ D$ shifts rightward and increases the nominal exchange rate, e. This is known as appreciation of the dollar.Be1Events which decrease the demand for the dollar, and thus decrease e would be a depreciation of the dollar.
20 Real Exchange Rate,eThe real exchange rate is the relative price of the goods of two countries. That is, the real exchange rate tells us the rate at which we can trade the goods of one country for the goods of another.To see the difference between the real and nominal exchange rates,consider a single good produced in many countries: cars. Suppose anAmerican car costs $10,000 and a similar Japanese car costs 2,400,000yen. To compare the prices of the two cars, we must convert them intoa common currency. If a dollar is worth 120 yen, then the Americancar costs 1,200,000 yen. Comparing the price of the American car(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), weconclude that the American car costs one-half of what the Japanesecar costs. In other words, at current prices, we can exchange 2American cars for 1 Japanese car.
21 e Real Exchange Rate, We can summarize our calculation as follows: Real Exchange Rate = (120 yen/dollar) (10,000 dollars/American car)(2,400,000 yen/Japanese Car)= 0.5 Japanese CarAmerican CarAt these prices, and this exchange rate, we obtain one-half of a Japanesecar per American car. More generally, we can write this calculation as Real Exchange Rate =Nominal Exchange Rate Price of Domestic GoodPrice of Foreign GoodThe rate at which we exchange foreign and domestic goods depends onthe prices of the goods in the local currencies and on the rate at whichthe currencies are exchanged.
22 Relationship between the real and nominal exchange rate e = e × (P/P*)Nominal ExchangeRateReal ExchangeRateRatio of PriceLevelsNote: P is the price level of the domestic country (measuredin the domestic currency) and P* is the price level of theforeign country (measured in the foreign currency).
23 e = e × (P/P*) Real Exchange Rate Nominal Exchange Rate Ratio of Price LevelsThe real exchange rate between two countries is computed from the nominal exchange rate and the price levels in the two countries. If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. If the real exchange rate is low, foreign goods are relatively expensive, and domestic goodsare relatively cheap.
24 Purchasing Power Parity How does the level of prices effect exchange rates? It doesn’t. All changes in a nation’s price level will be fully incorporated into the nominal exchange rate. It is the law of one price applied to the international marketplace.Purchasing Power Parity suggests that nominal exchange rate movements primarily reflect differences in price levels of nations. It states that if international arbitrage is possible, then a dollar must have the same purchasing power in every country. Purchasing Power Parity does not always hold because some goods are not easily traded, and sometimes traded goods are not always perfect substitutes– but it does give us reason to expect that fluctuations in the real exchange rate will be small and short-lived.
25 Purchasing Power Parity The law of one price applied to theinternational marketplace suggests thatnet exports are highly sensitive to smallmovements in the real exchange rate.This high sensitivity is reflected herewith a very flat net-exports schedule.Realexchangerate, eS-INX(e)Net Exports, NX
26 The Real Exchange Rate and the Trade Balance The relationship between the real exchange rate and net exports is negative: the lower the real exchange rate, the less expensive are domestic goods relative to foreign goods, and thus the greater are our net exports.NX(e)Net Exports, NXRealexchangerate, eThe real exchange rate is determined by theintersection of the vertical line representingsaving minus investment and downward-slopingnet exports schedule.S-IHere the quantity of dollarssupplied for net foreigninvestment equals thequantity of dollars demandedfor the net exports of goodsand services.
27 The Impact of Expansionary Fiscal Policy at Home on the Real Exchange Rate Net Exports, NXRealexchangerate, eNX1The fall in saving reduces the supply of dollarsto be exchanged into foreign currency, fromS1-I to S2-I. This shift raises the equilibrium realexchange rate from e1 to e2.S1-IExpansionary fiscal policy at home, such as anincrease in government purchases G or a cut intaxes, reduces national saving.e2e1NX(e)A reduction in saving reducesthe supply of dollars whichcauses the real exchange rateto rise and causes net exportsto fall.NX2
28 The Impact of Expansionary Fiscal Policy Abroad on the Real Exchange Rate The increase in the world interest rate reducesinvestment at home, which in turn raises thesupply of dollars to be exchanged into foreigncurrencies.S-I (r2*)Expansionary fiscal policy abroad reduces world saving and raises the world interest rate from r1* to r2*.NX(e)Net Exports, NXRealexchangerate, eNX2S-I(r1*)e1e2As a result, the equilibriumreal exchange rate falls frome1 to e2.NX1
29 The Impact of an Increase in Investment Demand on the Real Exchange Rate As a result, the supply of dollars to beexchanged into foreign currencies fallsfrom S-I1 to S-I2.S-I1An increase in investment demand raises the quantity of domestic investment from I1to I2.NX(e)Net Exports, NXRealexchangerate, eNX1S-I2e2This fall in supply raises the equilibrium real exchange rate from e1 to e2.e1NX2
30 Key Concepts of Ch. 5 Net exports Trade balance Net capital outflow Trade surplus and trade deficitBalanced tradeSmall open economyWorld interest rateNominal exchange rateReal exchange ratePurchasing-power parity