The Goods Market in an Open Economy Econ 302 Slide #1 Current Account Exports931 Imports1100 Trade balance (deficit = -) (1)-169 Investment income received242 Investment income paid265 Net investment income (2)-23 Net transfers received (3)-41 Current account balance (deficit = -) (1)+(2)+(3)-233 Capital Account Increase in foreign holdings of U.S. assets542 Increase in U.S. holdings of foreign assets305 Net increase in foreign holdings/net capital flow to the U.S.237 Statistical discrepancy4 Openness in Goods and Financial Markets Openness in Financial Markets The Relation Between Trade and Financial Flows The U.S. Balance of Payments, 1998

The Goods Market in an Open Economy Econ 302 Slide #2 Openness in Goods and Financial Markets Openness in Financial Markets The Balance of Payments The Current Account (Above the Line) All recorded payments to and from the rest of the world 1.Trade in Goods and Services * Exports: Payments from the rest of the world ($931 Billion) * Imports: Payments to the rest of the world ($1,100 Billion) 2.Investment Income * U.S. residents receive income on their holdings of foreign assets ($242 Billion) * Foreign residents receive income on their holdings of U.S. assets ($265 Billion)

The Goods Market in an Open Economy Econ 302 Slide #3 Openness in Goods and Financial Markets Openness in Financial Markets The Balance of Payments (Continued) The Current Account (Above the Line) All recorded payments to and from the rest of the world 3.Foreign Aid (-$41 Billion) * Net transfers received The difference between foreign aid received and given 4.Current account balance (+,-)= 1+2+3= -$233 Billion (1998)

The Goods Market in an Open Economy Econ 302 Slide #4 Openness in Goods and Financial Markets Openness in Financial Markets The Balance of Payments The Capital Account 1.Increase in foreign holdings of U.S. assets ($542 Billion) 2.Increase in U.S. holdings of foreign assets ($305 Billion) 3.Net capital flows = 1-2 ($542 Billion - $305 Billion = -237 Billion) Statistical discrepancy: Accounts for differences in data sources.

The Goods Market in an Open Economy Econ 302 Slide #5 Openness in Goods and Financial Markets Openness in Financial Markets The Balance of Payments The Current Account Balance (+,-) = Capital Account Balance (+,-) A Current Account Deficit increases foreign holdings of U.S. assets and vice versa.

The Goods Market in an Open Economy Econ 302 Slide #6 Openness in Goods and Financial Markets Openness in Financial Markets The Choice Between Domestic and Foreign Assets US Bonds i t = U.S. nominal interest rate (1+i t ) = Return next year /$purchase of U.S. bonds An Example: Choose between U.S. and German 1 yr. bonds

The Goods Market in an Open Economy Econ 302 Slide #7 Openness in Goods and Financial Markets Openness in Financial Markets Expected Returns from Holding One-Year U.S. or German Bonds U.S. bonds German bonds Year t Year t+1 $1$(1+i t )

The Goods Market in an Open Economy Econ 302 Slide #8 Openness in Goods and Financial Markets Openness in Financial Markets The Choice Between Domestic and Foreign Assets If:Investors will hold only the asset with the highest rate of return. Then:To hold both U.S. and German bonds, they must have the same return. Or: U.S. Bond Return German Bond Return =

The Goods Market in an Open Economy Econ 302 Slide #9 Openness in Goods and Financial Markets Openness in Financial Markets The Choice Between Domestic and Foreign Assets (Continued) U.S. Bond Return German Bond Return = A little reorganizing: The Interest Parity Condition:

The Goods Market in an Open Economy Econ 302 Slide #10 Openness in Goods and Financial Markets Openness in Financial Markets The Choice Between Domestic and Foreign Assets Is the assumption that investors hold only assets with the highest expected return realistic? Some other considerations: -- Transaction Costs -- Exchange Rate Risk Observation: The interest parity condition is a good approximation for developed countries with open, well-organized financial markets.

The Goods Market in an Open Economy Econ 302 Slide #11 Openness in Goods and Financial Markets Openness in Financial Markets The Choice Between Domestic and Foreign Assets Adjusting the interest rate parity condition for changes in the value of the domestic currency The Interest Parity Condition: Or: = Expected rate of depreciation of the domestic currency

The Goods Market in an Open Economy Econ 302 Slide #12 Openness in Goods in Financial Markets Openness in Financial Markets The Choice Between Domestic and Foreign Assets (Continued) An approximation:

The Goods Market in an Open Economy Econ 302 Slide #13 Openness in Goods and Financial Markets Some Conclusions Goods Openness allows choice between domestic goods and foreign goods. Which goods are chosen depends primarily on the exchange rate. Financial Assets Openness allows choice between domestic and foreign assets. Which assets are chosen depends primarily on: Relative rates of return Expected rate of depreciation of the domestic currency

The Goods Market in an Open Economy Econ 302 Slide #14 The Goods Market in an Open Economy Expanding the Goods Market Model (IS) to address these questions Can a foreign expansion stimulate domestic economic growth? Should macroeconomic policies be coordinated between countries?

The Goods Market in an Open Economy Econ 302 Slide #15 The IS Relation in the Open Economy The Open Economy Demand for Domestic Goods... Z  C + I + G -  Q + X  Q: The value of imports in terms of domestic goods X:Exports

The Goods Market in an Open Economy Econ 302 Slide #16 The IS Relation in the Open Economy The Determinants of the Demand for Domestic Goods The Determinants of C, I, & G Domestic Demand: C + I + G = C(Y-T) + I(Y,r) + G ( + ) (+,-) The Determinants of Imports Imports: Q = Q(Y,  ) (+, - ) The Determinants of Exports Exports: X = X(Y*,  ) (+, +)

The Goods Market in an Open Economy Econ 302 Slide #17 The IS Relation in the Open Economy The Open Economy Graphically Demand Output Demand Output DD Domestic demand (C + I + G) DD Observations Difference between DD & AA increases with income AA is flatter than DD AA has a positive slope AA Imports (  Q)

The Goods Market in an Open Economy Econ 302 Slide #18 NX BC Y Y Exports (X) ZZ Demand Output DD AA The IS Relation in the Open Economy The Open Economy Graphically Y < Y TB Trade surplus Y > Y TB Trade deficit Y TB A B AB: Imports BC: Net Exports (X –  Q) Demand for Domestic Goods Including Exports (ZZ) C AC: Exports 0 Net exports, NX Output, Y Net Exports (NX) = X -  Q

The Goods Market in an Open Economy Econ 302 Slide #19 The IS Relation in the Open Economy Equilibrium Output and the Trade Balance Goods Market Equilibrium: Y = Z Domestic Output Demand for Domestic Goods = Y = C(Y-T) + I(Y,r) + G -  Q(Y,  ) + X(Y*,  )

The Goods Market in an Open Economy Econ 302 Slide #20 NX Y TB The IS Relation in the Open Economy Equilibrium Output and the Trade Balance Demand, Z Output ZZ A Y Z Equilibrium Y = Z C B Y Trade deficit 0 Net exports, NX Output, Y

The Goods Market in an Open Economy Econ 302 Slide #21 Demand, Z Output ZZ A Initial equilibrium Y ZZ´ (  G > 0)  G > 0 The IS Relation in the Open Economy Increases in Demand, Domestic or Foreign Increases in Domestic Demand Assume G is increased to increase domestic demand & Y NX 0 Net exports, NX Output, Y Y Y TB Initial equilibrium Y = Y TB C B A´ New Equilibrium (  Y >  G) Trade deficit Y´

The Goods Market in an Open Economy Econ 302 Slide #22 The IS Relation in the Open Economy Increases in Demand, Domestic or Foreign The Impact of Increasing G in an Open Economy Some Observations A trade deficit is created The multiplier is smaller Question:How are the trade deficit and the smaller multiplier related?

The Goods Market in an Open Economy Econ 302 Slide #23 The IS Relation in the Open Economy Increases in Demand, Domestic or Foreign The Impact of Increasing G in an Open Economy Observation: The more open an economy, the smaller the impact of a change in domestic demand on output. Example: Belgium:Ratio of imports to GDP is 70%. Therefore, 70% of an increase in domestic demand will go for imports. U.S.:Import ratio = 13% Even in the U.S. domestic policy is reduced by the open economy.

The Goods Market in an Open Economy Econ 302 Slide #24 Demand, Z Output ZZ A Y DD ZZ´ XX NX´ XX NX 0 Net exports, NX Output, Y Y Y TB The IS Relation in the Open Economy Increases in Demand, Domestic or Foreign Increases in Foreign Demand Y´ A´ Y´  NX Domestic demand  NX Demand for domestic goods D C A: Initial equilibrium & balanced trade Y*: Increases &  X A´: New equilibrium

The Goods Market in an Open Economy Econ 302 Slide #25 The IS Relation in the Open Economy Increases in Demand, Domestic or Foreign Increases in Foreign Demand A Summary Increase in Y* increases demand for domestic goods, exports grow and equilibrium Y increases. The increase in Y increases imports. The increase in imports is less than the growth in exports.

The Goods Market in an Open Economy Econ 302 Slide #26 The IS Relation in the Open Economy Increases in Demand, Domestic or Foreign Two Observations: Increase in domestic demand leads to an increase in Y and a trade deficit. 1. Increase in foreign demand leads to an increase in Y and a trade surplus. 2.

The Goods Market in an Open Economy Econ 302 Slide #27 The IS Relation in the Open Economy Depreciation, the Trade Balance, and Output The Depreciation of a Currency ($) Real Exchange Rate:E:Nominal exchange rate P*:Foreign price level P:Domestic price level Recall: Assuming Constant Prices: The depreciation of a currency ($) will make that country’s goods cheaper in other countries and vice versa.

The Goods Market in an Open Economy Econ 302 Slide #28 The IS Relation in the Open Economy Depreciation, the Trade Balance, and Output Depreciation and the Trade Balance: The Marshall-Lerner Condition Net Exports:NX  X -  Q NX = X(Y*,  ) -  Q(Y,  ) Depreciation (increase in  ) affects the trade balance in three ways: 1.X increases 2.Q decreases 3.  Q increases The Marshall-Lerner Condition: For depreciation to improve the trade balance--the increase in X and decrease in Q is greater than the increase in  Q.

The Goods Market in an Open Economy Econ 302 Slide #29 The IS Relation in the Open Economy Depreciation, the Trade Balance, and Output The Effects of a Depreciation Tracing a Depreciation Through the Economy 1.Shift demand, both foreign and domestic toward domestic goods 2.Net exports increase (Marshall-Lerner) 3.Equilibrium Y increases 4.Trade balance improves

The Goods Market in an Open Economy Econ 302 Slide #30 The IS Relation in the Open Economy Combining Exchange Rate and Fiscal Policies Objective: Reduce the trade deficit without changing Y Policy: Balance depreciation and fiscal constraint Depreciation, the Trade Balance, and Output ZZ´ A´ Y´  NX Depreciation shifts ZZ to ZZ´ & Y to Y´ Reduction in G shifts ZZ´ to ZZ & Y GG NX´  NX B Depreciation shifts NX to NX´ & balanced trade Demand, Z Output ZZ A Y NX 0 Net exports, NX Output, Y Y Initial equilibrium C

The Goods Market in an Open Economy Econ 302 Slide #31 The IS Relation in the Open Economy Combining Exchange Rate and Fiscal Policies Depreciation, the Trade Balance, and Output Exchange Rate and Fiscal Policy Combinations Initial ConditionsTrade SurplusTrade Deficit Low output  ? G    G? High output   G?  ? G 

The Goods Market in an Open Economy Econ 302 Slide #32 The IS Relation in the Open Economy Looking at Dynamics: The J-Curve Depreciation 0 Net exports, NX Time C A B 0 _ +

The Goods Market in an Open Economy Econ 302 Slide #33 The IS Relation in the Open Economy The Real Exchange Rate and the Ratio of Net Exports to GDP: U.S.,

The Goods Market in an Open Economy Econ 302 Slide #34 The IS Relation in the Open Economy Looking at Dynamics - The J-Curve The U.S Movements real exchange rates were reflected in parallel movements in net exports. 2.There were substantial lags in the response of the trade balance to changes in the real exchange rate. The J-Curve at work.

The Goods Market in an Open Economy Econ 302 Slide #35 The IS Relation in the Open Economy Saving, Investment, and Trade Deficits Subtract C + T from both sides: S = I + G - T -  Q + X And using NX  X -  Q Recall: Y = C + I + G -  Q + X and S = Y - C + T NX = S + (T - G) - I Trade Balance SavingInvestment = -

The Goods Market in an Open Economy Econ 302 Slide #36 The IS Relation in the Open Economy Saving, Investment, and Trade Deficits Observations: NX = S + (T-G) - I Trade surplus: Excess of saving over investment Trade deficit:Excess of investment over saving An increase in investment must be reflected either in an increase in private or public saving or in a deterioration of the trade balance. An increase in the budget deficit must be reflected in an increase in private saving, decrease in investment, or a deterioration of the trade balance. A country with a high saving rate, public and private, must have a high investment rate or a large trade surplus.

The Goods Market in an Open Economy Econ 302 Slide #37 The IS Relation in the Open Economy Increases in Demand, Domestic or Foreign Games that Countries Play A Scenario... There is a group of countries that are trading partners. The countries are in a recession The countries have balanced trade Questions: Why would any one country be reluctant to expand domestic demand? What would be the impact on the trade balance if all countries increased domestic demand together?

The Goods Market in an Open Economy Econ 302 Slide #38 The IS Relation in the Open Economy Increases in Demand, Domestic or Foreign Games that Countries Play Coordination:As global commerce expands, the motivation for coordination increases. For example, the G7 meetings. The Evidence:There is very little limited macro-coordination. Barriers to Coordination: Not all countries experience the same economic conditions. Budget and trade balances may differ. Countries have an incentive to promise and then not deliver on the promise.

The Goods Market in an Open Economy Econ 302 Slide #39 Equilibrium in the Goods Market (IS) Output - Demand for Domestic Goods Y = C(Y-T) + I(Y,r) + G -  Q(Y,  ) + X(Y*,  ) ( + ) (+,-) (+, -) (+, +) Output, the Interest Rate, and the Exchange Rate Net Exports = X -  Q NX(Y,Y*,  )  X(Y*,  ) -  Q(Y,G) Y = C(Y-T) + I(Y,r) + G + NX(Y,Y*,  ) Observation:Equilibrium Y & Demand depend on the… real interest rate (r) real exchange rate (  )  r   I   Demand  Multiplier   Y     Demand for Domestic Goods   Demand  Y

The Goods Market in an Open Economy Econ 302 Slide #40 Equilibrium in the Goods Market (IS) Some Assumptions Output, the Interest Rate, and the Exchange Rate Y = C(Y-T) + I(Y,i) + G + NX(Y,Y*, E) ( + ) (+,-) (-, +, + ) The domestic price level is given (  e = O & r = i) The foreign price level is given (  & E move together) P*/P = I &  = E New Equilibrium Statement

The Goods Market in an Open Economy Econ 302 Slide #41 Equilibrium in the Financial Markets Money vs. Bonds Output, the Interest Rate, and the Exchange Rate Money: Equilibrium in the money market in an open economy Supply of money = Demand for money = YL(i)

The Goods Market in an Open Economy Econ 302 Slide #42 Equilibrium in the Financial Markets Money vs. Bonds Output, the Interest Rate, and the Exchange Rate Domestic Bonds vs. Foreign Bonds Equilibrium in domestic bonds and foreign bonds Interest parity relation: Domestic i = Foreign i + Expected Depreciation

The Goods Market in an Open Economy Econ 302 Slide #43 Equilibrium in the Financial Markets Money vs. Bonds Output, the Interest Rate, and the Exchange Rate Domestic Bonds vs. Foreign Bonds (Continued) Equilibrium in domestic bonds and foreign bonds Assume: Then: Solving for E:

The Goods Market in an Open Economy Econ 302 Slide #44 Equilibrium in the Financial Markets Domestic Bonds vs. Foreign Bonds Output, the Interest Rate, and the Exchange Rate Interpreting:  i  Exchange Rate (appreciation of domestic currency)  i*  Exchange Rate (depreciation of domestic currency)

The Goods Market in an Open Economy Econ 302 Slide #45 Equilibrium in the Financial Markets Domestic Bonds vs. Foreign Bonds Output, the Interest Rate, and the Exchange Rate An example: The adjustment of exchange markets to an increase in U.S. interest rates above German rates Initially: i = i* & E=E e U.S. monetary contraction increases i, if E is constant U.S. bonds become more attractive i > i* To buy U.S. bonds, Germans must sell German bonds for DM, then sell DM for $s and the $ appreciates. To maintain equilibrium:  the $ appreciation until the expected future depreciation compensates for the increase in i

The Goods Market in an Open Economy Econ 302 Slide #46 Equilibrium in the Financial Markets Domestic Bonds vs. Foreign Bonds Output, the Interest Rate, and the Exchange Rate A numeric example: Assume: U.S. i & Di* = 4% Then U.S. i increases to 10% The $ will appreciate 6% At a 6% appreciation, holding U.S. or German bonds yields 10% in $s In terms of 10% = 4% + 6%

The Goods Market in an Open Economy Econ 302 Slide #47 Putting Goods and Financial Markets Together Output, the Interest Rate, and the Exchange Rate The goods market equilibrium depends, in part, on i & E Output: Y = C(Y-T) + I(Y,i) + G + NX(Y,Y*,E) The money market determines i Interest Rate: The interest parity condition implies i & E are negatively related. Exchange Rate:

The Goods Market in an Open Economy Econ 302 Slide #48 Equilibrium in Financial Markets The Relation Between the Interest Rate and the Exchange Rate Implied by Interest Parity A lower domestic interest rate leads to a higher exchange rate—to a depreciation of the domestic currency. A higher domestic interest rate leads to a lower exchange rate—to an appreciation of the domestic currency.

The Goods Market in an Open Economy Econ 302 Slide #49 Putting Goods and Financial Markets Together Output, the Interest Rate, and the Exchange Rate The goods market equilibrium depends, in part, on i & E (Continued) The Open-Economy IS-LM Model

The Goods Market in an Open Economy Econ 302 Slide #50 Putting Goods and Financial Markets Together Output, the Interest Rate, and the Exchange Rate Consider: If i increases: Direct Effect:  I   Y Indirect Effect: Domestic Currency Appreciates  NX    Y In an open economy is the multiplier larger or smaller?

The Goods Market in an Open Economy Econ 302 Slide #51 Fiscal Policy Output, the Interest Rate, and the Exchange Rate  G   Demand  Y   Money Demand   i makes domestic bonds more attractive  domestic currency appreciates  the higher i and appreciation reduce demand for domestic goods and offsets some of the effects of  G on Y. The Effects of Policy in an Open Economy A Summary:

The Goods Market in an Open Economy Econ 302 Slide #52 Putting Goods and Financial Markets Together The IS-LM Model in the Open Economy An increase in the interest rate reduces output both directly and indirectly (through the exchange rate). The IS curve is downward sloping. Given the real money stock, an increase in income increases the interest rate: The LM curve is upward sloping.

The Goods Market in an Open Economy Econ 302 Slide #53 The Effects of Policy in an Open Economy The Effects of an Increase in Government Spending An increase in government spending leads to an increase in output, an increase in the interest rate, and an appreciation The increase in government spending affects neither the LM curve nor the interest- parity curve.

The Goods Market in an Open Economy Econ 302 Slide #54 The Effects of Monetary Policy in an Open Economy The Effects of a Monetary Contraction A monetary contraction leads to a decrease in output, an increase in the interest rate, and an appreciation. The decrease in the money supply affects neither the IS curve nor the interest-parity curve.

The Goods Market in an Open Economy Econ 302 Slide #55 Fiscal Policy Output, the Interest Rate, and the Exchange Rate G: G  C: Increase in  Y   C I: Ambiguous:  Y   I &  i   I NX: Decrease: Appreciation &  Y   NX The Effects of Policy in an Open Economy Can we tell what happens to the various components of demand (C, I, G, NX) from the increase in G?

The Goods Market in an Open Economy Econ 302 Slide #56 Output, the Interest Rate, and the Exchange Rate Pegs, Crawling Pegs, Bans, the EMS, & the Euro Fixed Exchange Rates Exchange rate policies vary from country to country. Flexible exchange rates: The U.S. and Japan Fixed exchange rates: Pegs: Setting the exchange rate to the dollar or some other currencies. Adjust by evaluation and devaluation. Crawling Peg: Setting an exchange rate target. EMS: European Monetary System: Maintain bilateral exchange rates or band around a central parity.

The Goods Market in an Open Economy Econ 302 Slide #57 Output, the Interest Rate, and the Exchange Rate Pegging the Exchange Rate and Monetary Control Fixed Exchange Rates Assume: A country pegs its exchange at Given the interest parity condition: And:, then Recall the LM Relation: now i=i* or Therefore, to maintain, the money supply must be adjusted to keep i at i*.

The Goods Market in an Open Economy Econ 302 Slide #58 Fiscal Policy Under Fixed Exchange Rates The Effects of a Fiscal Expansion Under Fixed Exchange Rates Under flexible exchange rates, a fiscal expansion increases output, from Y A to Y B. Under fixed exchange rates, output increases from Y A to Y C. The central bank must accommodate the resulting increase in the demand for money.

The Goods Market in an Open Economy Econ 302 Slide #59 Good or Bad Idea? Fixed Exchange Rates Output, the Interest Rate, and the Exchange Rate With fixed exchange rates, a country…  Gives up a powerful tool for correcting trade imbalances and changing the level of economic activity.  Gives up control of its interest rate.  Must accommodate its fiscal policy with monetary policy. Are there any benefits to fixed exchange rates? This requires a look into the medium-run.