Lecture 11 Notes

HE191 Principles of Economics Lecture 11 Chapters 31 and 32 Principles of Economics, Fourth Edition N. Gregory Mankiw

In this lecture, look for the answers to these questions: „ How are international flows of goods and assets related? „ What’s the difference between the real and nominal exchange rate? „ What is “purchasing-power parity,” and how does it explain nominal exchange rates? „ In an open economy, what determines the real interest rate? The real exchange rate? „ How are the markets for loanable funds and foreigncurrency 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?

Closed vs. Open Economies „ A closed economy does not interact with other economies in the world. „ An open economy interacts freely with other economies around the world. The Flow of Goods & Services „ Exports: domestically-produced g&s sold abroad „ Imports: foreign-produced g&s sold domestically „ Net exports (NX) = value of exports – value of imports „ Another name for NX: the trade balance.

Variables that Influence Net Exports „ consumers’ preferences for foreign and domestic goods „ prices of goods at home and abroad „ incomes of consumers at home and abroad „ the exchange rates at which foreign currency trades for domestic currency „ transportation costs „ government policies

Trade Surpluses & Deficits NX measures the imbalance in a country’s trade

in goods and services.

„Trade deficit: an excess of imports over exports „Trade surplus: an excess of exports over imports „Balanced trade: when exports = imports

The Flow of Capital „ Net capital outflow (NCO): domestic residents’ purchases of foreign assets minus foreigners’ purchases of domestic assets „ NCO is also called net foreign investment. The flow of capital abroad takes two forms: ƒ Foreign direct investment: Domestic residents actively manage the foreign investment, e.g., McDonalds opens a fast-food outlet in Moscow. ƒ Foreign portfolio investment: Domestic residents purchase foreign stocks or bonds, supplying “loanable funds” to a foreign firm.

The Flow of Capital NCO measures the imbalance in a country’s trade in assets: „ When NCO > 0, “capital outflow” Domestic purchases of foreign assets exceed foreign purchases of domestic assets. „ When NCO < 0, “capital inflow” Foreign purchases of domestic assets exceed domestic purchases of foreign assets. Variables that Influence NCO „real interest rates paid on foreign assets and domestic assets „perceived risks of holding foreign assets „govt policies affecting foreign ownership of domestic assets

The Equality of NX and NCO „ An accounting identity: NCO = NX „ arises because every transaction that affects NX also affects NCO by the same amount (and vice versa) „ When a foreigner purchases a good from the U.S., „ U.S. exports and NX increase „ the foreigner pays with currency or assets, so the U.S. acquires some foreign assets, causing NCO to rise. „ When a U.S. citizen buys foreign goods, „ U.S. imports rise, NX falls „ the U.S. buyer pays with U.S. dollars or assets, so the other country acquires U.S. assets, causing U.S. NCO to fall.

Saving, Investment, and International Flows of Goods & Assets Y = C + I + G + NX

accounting identity

Y – C – G = I + NX

rearranging terms

S = I + NX S = I + NCO

since S = Y – C – G since NX = NCO

„ When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow. „ When S < I, foreigners are financing some of the country’s investment, and NCO < 0.

Case Study: The U.S. Trade Deficit „ In 2004, the U.S. had a record trade deficit. „ Recall, NX = S – I = NCO. A trade deficit means I > S, so the nation borrows the difference from foreigners. „ In 2004, foreign purchases of U.S. assets exceeded U.S. purchases of foreign assets by $585 million. „ Such deficits have been the norm since 1980…

Case Study: The U.S. Trade Deficit Why U.S. saving has been less than investment: „In the 1980s and early 2000s, huge budget deficits and low private saving depressed national saving. „In the 1990s, national saving increased as the economy grew, but domestic investment increased even faster due to the information technology boom.

Case Study: The U.S. Trade Deficit „ Is the U.S. trade deficit a problem? „ The extra capital stock from the ’90s investment boom may well yield large returns „ The fall in saving of the ’80s and ’00s, while not desirable, at least did not depress domestic investment, as firms could borrow from abroad

„ A country, like a person, can go into debt for good reasons or bad ones. A trade deficit is not necessarily a problem, but might be a symptom of a problem.

Case Study: The U.S. Trade Deficit as of 12-31-2004

People abroad owned $12.5 trillion in U.S. assets. U.S. residents owned $10 trillion in foreign assets. U.S.’ net indebtedness to other countries = $2.5 trillion. Higher than every other country’s net indebtedness. So, U.S. is “the world’s biggest debtor nation.” „ So far, the U.S. earns higher interest rates on foreign assets than it pays on its debts to foreigners. „ But if U.S. debt continues to grow, foreigners may demand higher interest rates, and servicing the debt would become a drain on U.S. income.

The Nominal Exchange Rate „ Nominal exchange rate: the rate at which one country’s currency trades for another „ We express all exchange rates as foreign currency per unit of domestic currency. „ Some exchange rates as of 19 Oct 2007, all per US$ Canadian dollar: 0.96 Euro: 0.70 Japanese yen: 115.15 Mexican peso: 10.79

Appreciation and Depreciation „ Appreciation (or “strengthening”): an increase in the value of a currency as measured by the amount of foreign currency it can buy „ Depreciation (or “weakening”): a decrease in the value of a currency as measured by the amount of foreign currency it can buy „ Examples: During 2005, the U.S. dollar… „appreciated 15% against the euro „depreciated 5% against the Mexican peso

The Real Exchange Rate „ Real exchange rate: the rate at which the g&s of one country trade for the g&s of another exP „ Real exchange rate = P* where P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate, i.e., foreign currency per unit of domestic currency

Example With One Good „ A Big Mac costs $2.50 in U.S., 400 yen in Japan „ e = 120 yen per $ „ e x P = price in yen of a U.S. Big Mac = (120 yen per $) x ($2.50 per Big Mac) = 300 yen per U.S. Big Mac „ Compute the real exchange rate: 300 yen per U.S. Big Mac exP = P* 400 yen per Japanese Big Mac = 0.75 Japanese Big Macs per US Big Mac

Interpreting the Real Exchange Rate “The real exchange rate = 0.75 Japanese Big Macs per U.S. Big Mac” „ This does not mean a Japanese citizen literally exchanges Japanese burgers for American ones. „ Correct interpretation: To buy a Big Mac in the U.S., a Japanese citizen must sacrifice an amount that could purchase 0.75 Big Macs in Japan.

The Real Exchange Rate With Many Goods P = U.S. price level, e.g., Consumer Price Index,

which measures the price of a basket of goods P* = foreign price level Real exchange rate = (e x P)/P* = price of a domestic basket of goods relative to price of a foreign basket of goods „ An appreciation of the U.S. real exchange rate means U.S. goods are becoming more expensive relative to foreign goods.

The Law of One Price „ Law of one price: the notion that a good should sell for the same price in all markets „Suppose coffee sells for $4/pound in Seattle and $5/pound in Boston, and can be costlessly transported. „There is an opportunity for arbitrage, making a quick profit by buying coffee in Seattle and selling it in Boston. „Such arbitrage drives up the price in Seattle and drives down the price in Boston, until the two prices are equal.

Purchasing-Power Parity (PPP) „ Purchasing-power parity: a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries „ based on the law of one price „ implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries

PPP and Its Implications „ PPP implies that the nominal P* exchange rate between two countries e = P should equal the ratio of price levels. „ If the two countries have different inflation rates, then e will change over time: „ If inflation is higher in Mexico than in the U.S., then P* rises faster than P, so e rises – the dollar appreciates against the peso. „ If inflation is higher in the U.S. than in Japan, then P rises faster than P*, so e falls – the dollar depreciates against the yen.

Limitations of PPP Theory Two reasons why exchange rates do not always adjust to equalize prices across countries: „ Many goods cannot easily be traded „ Examples: haircuts, going to the movies „ Price differences on such goods cannot be arbitraged away „ Foreign, domestic goods not perfect substitutes „ E.g., some U.S. consumers prefer Toyotas over Chevys, or vice versa „ Price differences reflect taste differences „ Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends. „ For example, PPP implies: the greater a country’s inflation rate, the faster its currency should depreciate (relative to a low-inflation country like the US).

Open Macroeconomics: The Market for Loanable Funds „ Recall the identity:

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

How NCO Depends on the Real Interest Rate The real interest rate, r, is the real return on r domestic assets. A fall in r makes domestic assets less attractive relative to foreign assets. r1 „ People in the U.S. r2 purchase more foreign assets. „ People abroad purchase fewer U.S. assets. „ NCO rises.

Net capital outflow

NCO NCO NCO1 NCO2

The Loanable Funds Market Diagram

r

Loanable funds

rr adjusts adjusts to to balance balance supply supply and and demand demand in in the the LF LF market. market.

S = saving

Both Both II and and NCO NCO depend depend negatively negatively on on r, r, so so the the D D curve curve is is downward-sloping. downward-sloping.

r1 D = I + NCO LF

The Market for Foreign-Currency Exchange „ Recall another identity: NCO = NX Net capital outflow

Net exports

„ In the market for foreign-currency exchange, „ NX is the demand for dollars, because foreigners need dollars to buy U.S. net exports. „ NCO is the supply of dollars, because U.S. residents sell dollars to obtain the foreign currency they need to buy foreign assets.

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. „ E adjusts to balance supply and demand for dollars in the market for foreign- currency exchange.

The Market for Foreign-Currency Exchange An increase in E makes E U.S. goods more expensive to foreigners, reduces foreign demand for U.S. goods – and E1 U.S. dollars. An increase in E has no effect on saving or investment, so it does not affect NCO or the supply of dollars.

S = NCO

D = NX Dollars

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.

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.

The “Twin

Net Net exports exports and and the the budget budget deficit deficit Deficits” often often move move in in opposite opposite directions. directions.

5% 3%

U.S. federal budget deficit

2% 1% 0% -1% -2% -3%

U.S. net exports

2001-05

1991-95

1986-90

1981-85

1976-80

1971-75

1966-70

-5%

1995-2000

-4% 1961-65

Percent of GDP

4%

The Effects of a Budget Deficit: Summary

• 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)

The Connection Betweenr r2 Interest Rates and Exchange Rates r1 NCO

Anything that increases r

NCO

will reduce NCO and the supply of dollars in the foreign exchange market. Result: The real exchange rate appreciates.

NCO2 E

S2

NCO1 S1 = NCO1

E2 E1 D = NX dollars NCO2

NCO1

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.

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

Trade Policy „ Common reasons for policies to restrict imports: „ to save jobs in a domestic industry that has difficulty competing with imports „ to 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.

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.) r

Loanable funds

r

Net capital outflow

S

r1

r1 D

NCO LF

NCO

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.

Market for foreigncurrency exchange E

S = NCO

E2 E1 D2 D1 Dollars

Analysis of a Quota on Cars from Japan, cont. 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 auto imports

from Japan does not reduce the trade deficit.

Analysis of a Quota on Cars from Japan, cont. 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 only by destroying jobs in U.S. export industries!!

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.

Capital Flight from Mexico r

Loanable funds

r

Net capital outflow

S1 r2

r2

r1

r1 D1

D2

NCO2 NCO1

LF

NCO

As foreign investors sell their assets and pull out their capital, NCO increases at each value of r. Demand for LF = I + NCO. The increase in NCO increases demand for LF. The equilibrium values of r and NCO both increase.

Capital Flight from Mexico The increase in NCO causes an increase in the supply of pesos in the foreign exchange market.

Market for foreigncurrency exchange E

S1 = NCO1 S2 = NCO2

The real exchange rate value of the peso falls. E1 E2 D1 Pesos

Real-World Examples of Capital Flight „ Mexico, 1994 „ Southeast Asia, 1997 „ Russia, 1998 „ Argentina, 2002 In In each each of of these these cases, cases, the ’s interest the country country’s interest rates rates rose rose and and its its exchange exchange rate rate depreciated, depreciated, as as our our model model predicts. predicts.