A Macroeconomic Theory of the Open Economy 32 A Macroeconomic Theory of the Open Economy Economics P R I N C I P L E S O F N. Gregory Mankiw Many instructors skip this chapter. I encourage you to consider keeping it: it sheds light on some of the most important and compelling topics in economics, and I have worked hard to make this PowerPoint easy to teach and easy to learn. Students will learn in this chapter what I believe is one of the most important lessons economics has to offer the educated layperson: Trade policies designed to save jobs in one industry do so only by destroying jobs in other industries. This case against restricting imports has a much greater emotional impact on students than the deadweight loss triangles students learn in their micro courses. The chapter also covers capital flight, the twin deficits, and – new to the 5th edition – a nice case study on capital flows from China. Students can use the concepts in this chapter to better understand a very topical issue: the recent, sharp depreciation of the U.S. dollar. This PowerPoint presentation helps them do that with a new case study on the falling dollar. Professors know that this chapter is one of the most difficult in the textbook. Yet, I have worked hard to make this presentation easy for you to teach and easy for students to learn. I hope you will consider covering it. Premium PowerPoint Slides by Ron Cronovich

In this chapter, 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? 1

Introduction The previous chapter explained the basic concepts and vocabulary of the open economy: net exports (NX), net capital outflow (NCO), and exchange rates. This chapter ties these concepts together into a theory of the open economy. We will use this theory to see how govt policies and various events affect the trade balance, exchange rate, and capital flows. We start with the loanable funds market… A MACROECONOMIC THEORY OF THE OPEN ECONOMY 2

The Market for Loanable Funds An identity from the preceding chapter: S = I + NCO Saving Domestic investment Net capital outflow Supply of loanable funds = saving. A dollar of saving can be used to finance the purchase of domestic capital the purchase of a foreign asset So, demand for loanable funds = I + NCO A MACROECONOMIC THEORY OF THE OPEN ECONOMY 3

The Market for Loanable Funds Recall: S depends positively on the real interest rate, r. I depends negatively on r. What about NCO? A MACROECONOMIC THEORY OF THE OPEN ECONOMY 4

How NCO Depends on the Real Interest Rate The real interest rate, r, is the real return on domestic assets. A fall in r makes domestic assets less attractive relative to foreign assets. People in the U.S. purchase more foreign assets. People abroad purchase fewer U.S. assets. NCO rises. Net capital outflow r NCO NCO r1 NCO1 r2 NCO2 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 5

The Loanable Funds Market Diagram r adjusts to balance supply and demand in the LF market. Loanable funds r LF S = saving Both I and NCO depend negatively on r, so the D curve is downward-sloping. D = I + NCO r1 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 6

A C T I V E L E A R N I N G 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. 7

A C T I V E L E A R N I N G 1 Answers A C T I V E L E A R N I N G 1 Answers When working with this model, keep in mind: the LF market determines r (in left graph), then this value of r determines NCO (in right graph). A budget deficit reduces saving and the supply of LF, causing r to rise. The higher r makes U.S. bonds more attractive relative to foreign bonds, reduces NCO. Loanable funds Net capital outflow r LF r NCO S2 S1 NCO1 D1 r2 r2 This is the first time students are seeing the two graphs together. Be sure to point out that the vertical axis of both graphs measures the same variable on the same scale. Hence, r1 in the graph on the left is the same as r1 in the graph on the right. Also, be sure to mention the direction of causality: the LF market diagram determines r, and then this value of r determines NCO in the diagram on the right. r1 r1 8

The Market for Foreign-Currency Exchange Another identity from the preceding chapter: NCO = NX Net capital outflow Net exports In the market for foreign-currency exchange, 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. That NX = demand for dollars and NCO = supply of dollars is critically important. Make sure to allow enough time for students to write this down in their notes. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 9

The Market for Foreign-Currency Exchange Recall: 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. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 10

The Market for Foreign-Currency Exchange An increase in E makes U.S. goods more expensive to foreigners, reduces foreign demand for U.S. goods – and U.S. dollars. E adjusts to balance supply and demand for dollars in the market for foreign- currency exchange. S = NCO E Dollars D = NX E1 An increase in E has no effect on saving or investment, so it does not affect NCO or the supply of dollars. The 5th edition has a new paragraph with more intuition explaining why the S/NCO curve is vertical rather than positively sloped. Here’s a quick summary: If E rises, our dollars can buy more foreign assets (perhaps 60,000 pesos worth of Mexican bonds instead of 50,000). Yet, what we care about is the rate of return on foreign assets. This return does not depend on whether E is high or low. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 11

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. It might be worth elaborating for a moment on the parenthetical remark: “Hence, NX is really the net demand for dollars.” What we mean is that NX equals foreign demand for dollars to purchase U.S. exports minus U.S. supply of dollars to purchase imports. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 12

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. Again, please consider elaborating on the parenthetical remark: “So, NCO is really the net supply of dollars.” It means that NCO equals U.S. supply of dollars to purchase foreign assets minus foreign demand for dollars to purchase U.S. assets. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 13

A C T I V E L E A R N I N G 2 The budget deficit, exchange rate, and 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? This exercise, like the previous one, lets students work with one piece of the larger model before putting all the pieces together. 14

A C T I V E L E A R N I N G 2 Answers Market for foreign-currency exchange The budget deficit reduces NCO and the supply of dollars. The real exchange rate appreciates, reducing net exports. Since NX = 0 initially, the budget deficit causes a trade deficit (NX < 0). S2 = NCO2 E Dollars S1 = NCO1 E2 E1 D = NX 15

U.S. federal budget deficit The “Twin Deficits” Net exports and the budget deficit often move in opposite directions. 5% U.S. federal budget deficit 4% 3% 2% 1% Percent of GDP U.S. net exports 0% -1% -2% Data are 5-year averages of quarterly data. (This model applies to the long run, so using high-frequency data is not appropriate.) Of course, there is not a perfect negative correlation. Other factors affect the trade deficit besides the budget deficit. For example, consider the recession of 1990-91. The budget deficit increased, as usual in recessions, due to the fall in tax revenues and rise in automatic-stabilizer spending (like unemployment insurance benefits). Net exports increased (i.e., the trade deficit fell) due to a fall in imports. But more generally, the data show that increases in the budget deficit are associated with decreases in the trade balance, as students found using the model in the preceding Active Learning exercises. Source: Bureau of Economic Analysis, Department of Commerce. I got the data from http://research.stlouisfed.org/fred2/ -3% -4% -5% 1961-65 1966-70 1971-75 1976-80 1981-85 1986-90 1991-95 1995-2000 2001-05 16

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) A MACROECONOMIC THEORY OF THE OPEN ECONOMY 17

SUMMARY: The Effects of a Budget Deficit 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. 31 December 2007 Value of U.S.-owned foreign assets $17.6 trillion Value of foreign-owned U.S. assets $20.1 trillion U.S.’ net debt to the rest of the world $2.5 trillion The last figure in the table, the U.S.’ net debt to the rest of the world, is bigger than any other country’s net debt to the rest of the world. Hence the expression “the U.S. is the world’s biggest debtor nation.” Source: Bureau of Economic Analysis, Department of Commerce Every June, the BEA publishes data for the previous year. By the time you teach this, the 2007 data will probably be available at the BEA’s website. If you’d like to update this chart, it’s pretty easy to find the data: 1. Visit the BEA’s website: http://www.bea.gov 2. Under “international,” click on “international investment position.” 3. Download or open the table from the news release – it’s an Excel file. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 18

The Connection Between Interest Rates and Exchange Rates r NCO NCO r2 NCO2 r1 S1 = NCO1 Keep in mind: The LF market (not shown) determines r. This value of r then determines NCO (shown in upper graph). This value of NCO then determines supply of dollars in foreign exchange market (in lower graph). Anything that increases r will reduce NCO and the supply of dollars in the foreign exchange market. Result: The real exchange rate appreciates. NCO1 S2 E dollars D = NX In earlier slides, students analyzed the effects of a budget deficit on the real interest rate and net capital outflow separately from the effects of a change in NCO on the exchange rate. This slide makes the connection between these events more explicit. Please point out to your students that both diagrams measure the same units on the horizontal axis. This slide also reviews the order and direction of causality among the three diagrams: 1. The LF market determines the equilibrium value of r. 2. This value of r and the NCO curve determine the equilibrium value of NCO. 3. This value of NCO determines the position of the vertical supply curve in the foreign exchange market. 4. The real exchange rate adjusts to equate demand (net exports) with supply (NCO) in the foreign exchange market. Students are much less likely to answer exam questions incorrectly if they carefully study this order and direction of causality among the various parts of this complicated model. E2 E1 NCO2 NCO1 19 19

A C T I V E L E A R N I N G 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 Students should find this policy experiment familiar; it was covered in the closed-economy loanable funds model from the chapter “Saving, Investment, and the Financial System.” 20

A C T I V E L E A R N I N G 3 Answers r rises, causing NCO to fall. Investment – and the demand for LF – increase at each value of r. Loanable funds Net capital outflow r LF r NCO S1 D2 NCO D1 r2 r2 NCO2 r1 r1 NCO1 21

A C T I V E L E A R N I N G 3 Answers Market for foreign-currency exchange The fall in NCO reduces the supply of dollars in the foreign exchange market. The real exchange rate appreciates, reducing net exports. S2 = NCO2 E Dollars S1 = NCO1 E2 E1 D = NX 22

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. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 23

Trade Policy Trade policy: a govt policy that directly influences the quantity of g&s that a country imports or exports Examples: Tariff – a tax on imports Import quota – a limit on the quantity of imports “Voluntary export restrictions” – the govt pressures another country to restrict its exports; essentially the same as an import quota A MACROECONOMIC THEORY OF THE OPEN ECONOMY 24

Trade Policy Common reasons for policies to restrict imports: Common reasons for policies to 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? Let’s use our model to analyze the effects of an import quota on cars from Japan designed to save jobs in the U.S. auto industry. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 25

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.) Loanable funds Net capital outflow r LF r NCO S NCO D The supply of loanable funds is saving, which equals Y – C – G. A quota on imports does not affect Y or C or G, so it will not affect saving. The demand for loanable funds equals investment + NCO, neither of which are affected by import quotas. Hence, r will not change. The NCO curve does not shift in response to the import quota. The import quota is a restriction on international trade in goods & services. The NCO curve describes international trade in assets. Hence, the equilibrium value of NCO is not affected by the import quota. r1 r1 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 26

Analysis of a Quota on Cars from Japan Since NCO unchanged, S curve does not shift. The D curve shifts: At each E, imports of cars fall, so net exports rise, D shifts to the right. At E1, there is excess demand in the foreign exchange market. E rises to restore eq’m. S = NCO E Dollars D1 E1 Market for foreign-currency exchange D2 E2 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 27

Analysis of a Quota on Cars from Japan 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. The import quota on cars from Japan ends up having almost no macroeconomic effects. In particular, it does not affect the equilibrium values of r, S, I, NCO, or NX. The only macro variable affected by the import quota is E, the real exchange rate. Yet, the policy does have important microeconomic effects, as the next slide discusses. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 28

Analysis of a Quota on Cars from Japan 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!! A restriction on imports has important microeconomic effects. It shifts demand to domestic autos, boosting output and employment in that industry. But the exchange rate appreciation reduces foreign demand for U.S. exports, depressing output and employment in those industries. If students have taken a semester of microeconomics, they have probably seen the deadweight loss triangles resulting from tariffs and quotas. On an intellectual level, they may understand what these deadweight losses represent. But job losses in struggling import-competing industries make a powerful impression on students. The analysis here shows that the jobs import restrictions save come at the expense of other jobs. Understanding this lesson shatters the most common populist reason for supporting protectionism. Also, if students remember anything about comparative advantage, they should understand that productivity is probably higher in the export sector, so wages are higher in the export sector, too. So it really doesn’t make sense to destroy good jobs in the export sector in order to save jobs in the lower-productivity import-competing sector. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 29

CASE STUDY: Capital Flows from China In recent years, China has accumulated U.S. assets 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 Some U.S. politicians want China to stop, argue for restricting trade with China to protect some U.S. industries. Yet, U.S. consumers benefit, and the net effect of China’s currency intervention is probably small. This slide is based on a new Case Study in the 5th edition. A MACROECONOMIC THEORY OF THE OPEN ECONOMY

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: a large and sudden reduction in the demand for assets located in a country We analyze this using our model, but from the prospective of Mexico, not the U.S. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 31

Capital Flight from Mexico Demand for LF = I + NCO. The increase in NCO increases demand for LF. The equilibrium values of r and NCO both increase. As foreign investors sell their assets and pull out their capital, NCO increases at each value of r. Loanable funds Net capital outflow r LF r NCO S1 NCO2 D2 NCO1 D1 r2 r2 r1 Students may ask “How can you be sure that NCO rises? Doesn’t the increase in r cause NCO to fall?” You can convince them that NCO rises using simple algebra: S = I + NCO NCO = S – I ΔNCO = ΔS – ΔI where, for any variable X, ΔX = the change in X from one equilibrium to another. Because r is higher in the new equilibrium, ΔS > 0 and ΔI < 0 Hence, it must be true that ΔNCO > 0. So, the increase in r reduces NCO somewhat, but not enough to reverse the initial capital outflow. r1 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 32

Capital Flight from Mexico Market for foreign-currency exchange E Pesos D1 S1 = NCO1 E1 The increase in NCO causes an increase in the supply of pesos in the foreign exchange market. The real exchange rate value of the peso falls. S2 = NCO2 E2 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 33

Examples of Capital Flight: Mexico, 1994 The textbook briefly discusses four recent examples of capital flight. Here are a few slides showing the behavior of the exchange rate in each episode. I would also like to include data on interest rates, but I cannot find reliable, weekly or monthly interest rate data for these countries. If you know of a good source, please let me know. Thanks! rcronovich@carthage.edu 34

Examples of Capital Flight: S.E. Asia, 1997 35

Examples of Capital Flight: Russia, 1998 36

Examples of Capital Flight: Argentina, 2002 37

CASE STUDY: The Falling Dollar 65 70 75 80 85 90 2005 2006 2007 2008 U.S. trade-weighted nominal exchange rate index, March 1973 = 100 From 10/2005 to 6/2008, the dollar depreciated 17.3% DISCLAIMER: This case study is not in the textbook and not supported with material in the study guide, instructors manual, or test bank, so please feel free to delete it. However, this is a very topical issue that many students want to better understand. (The Daily Show with Jon Stewart and the Colbert Report, two shows many college students watch, make jokes about the falling dollar on occasion.) Data description: Trade-weighted exchange index: major currencies. Source: Board of Governors, Federal Reserve, Release G.5 Foreign Exchange Rates I used the series TWEXMMTH from FRED: https://research.stlouisfed.org/fred2/ 38

CASE STUDY: The Falling Dollar Two likely causes: Subprime mortgage crisis Reduced confidence in U.S. mortgage-backed securities Increased NCO U.S. interest rate cuts From 7/2006 to 7/2008, Federal Funds target rate reduced from 5.25% to 2.00% to stimulate the sluggish U.S. economy. This case study is not intended as a definitive explanation of the causes of the falling dollar. Rather, it mentions two of the most likely causes of the falling dollar, which students can now better understand using the analysis in this chapter. Regarding the interest rate cuts: Students learned in this and the previous chapter how changes in interest rates affect NCO, which in turn affects the supply of dollars in the foreign exchange market, which in turn affects the exchange rate. What this chapter does NOT cover is how the Federal Reserve affects interest rates. The loanable funds framework in this chapter is not the best framework for illustrating Federal Reserve policy. (The loanable funds framework deals in flows, whereas we typically use the stocks model of money supply and demand to illustrate Fed policy.) Students can see a discussion and illustration of Federal Reserve interest rate policy in the chapters “The Monetary System” and “The Influence of Monetary and Fiscal Policy on Aggregate Demand”. A MACROECONOMIC THEORY OF THE OPEN ECONOMY

CONCLUSION The U.S. economy is becoming increasingly open: The U.S. economy is becoming increasingly open: Trade in g&s is rising relative to GDP. Increasingly, people hold international assets in their portfolios and firms finance investment with foreign capital. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 40

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. When politicians and commentators discuss international trade and finance, the lessons of this and the preceding chapter can help separate myth from reality. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 41

CHAPTER SUMMARY In an open economy, the real interest rate adjusts to balance the supply of loanable funds (saving) with the demand for loanable funds (domestic investment and net capital outflow). In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (net capital outflow) with the demand for dollars (net exports). Net capital outflow is the variable that connects these markets. 42

CHAPTER SUMMARY A budget deficit reduces national saving, drives up interest rates, reduces net capital outflow, reduces the supply of dollars in the foreign exchange market, appreciates the exchange rate, and reduces net exports. A policy that restricts imports does not affect net capital outflow, so it cannot affect net exports or improve a country’s trade deficit. Instead, it drives up the exchange rate and reduces exports as well as imports. 43

CHAPTER SUMMARY Political instability may cause capital flight, as nervous investors sell assets and pull their capital out of the country. As a result, interest rates rise and the country’s exchange rate falls. This occurred in Mexico in 1994 and in other countries more recently. 44