OPEN ECONOMY MACROECONOMICS

Chapter 28

Foreign Trade and Economic Activity

Net Exports and Output in the Open Economy

Open Economy Macroeconomics

- Study of how economies behave when the trade and financial linkages among nations are considered.

Exports -g/s produced domestically and purchased by foreigners

Net Exports = exports of g/s imports of g/s

Positive net exports: Net foreign investments Negative net exports: Foreign indebtedness is growing

Domestic expenditures equal to consumption plus domestic investment plus govt purchases. Difference between GDP and Domestic expenditures: 1. Some part of domestic expenditures will be on goods produced abroad. 2. Some part of domestic production will be sold abroad as exports

Total Domestic Output =

Domestic expenditures + Net exports =

GDP
C + I +G +X

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 Govt policies

Short Run Impact of Trade on GDP

Two new macroeconomic elements in international trade: 1. Net exports 2. An open economy has two different multipliers for private investments and govt domestic spending
Elements of Imports: Elements of Exports

Exogenous materials like prices and exchange rates Domestic Income and output

Exogenous materials like prices and exchange rates

Equilibrium output in an open economy occurs where total net domestic product and foreign spending equals total domestic output

Marginal Propensity to Import and the Spending line

The Open Economy Multiplier

1 = +

The effect of a sustained increase in government spending (or investment) on incomethat is, the multiplieris smaller in an open economy than in a closed economy. The reason: When government spending (or investment) increases and income and consumption rise, some of the extra consumption spending that results is on foreign products and not on domestically produced goods and services

The Monetary Transmission Mechanism in an Open Economy

Overvalued Currency: one whose value is high relative

to its long-run or sustainable level.

US dollar was overvalued in 1985

High mobility of financial capital: when financial

investments can flow easily among countries and the regulatory barriers to financial investments are low.
United States, Japan, countries of the European Union

Fixed Exchange Rates

Interest rates of countries with fixed exchange rates and

high capital mobility must be very closely aligned.

Any divergence between two countries will attract speculators who

will sell one currency and buy the other until the interest rates are equalized.

Fiscal policy is highly effective.

Flexible Exchange Rates

Has a reinforcing effect on monetary policy Monetary Easing Monetary Tightening

Monetary Easing

Monetary Easing

Lower interest rates

Depreciation of the currency

Stimulates Exports and discourages imports

Net export surplus

Increase domestic investment

Monetary Easing
Net export expansion
4500 4000 3500 3000 2500 2000 1500 1000 500 0 1000 2000

C + I + G + X(e**)

C + I + G + X(e*)

Q*

3000

Q**

4000

Monetary Tightening

Monetary tightening

High interest rates

Appreciati on of the currency

Increase in export prices and decrease in import prices

Net export deficit

Recession

SAVING AND INVESTMENT IN A SMALL OPEN ECONOMY

Small open economy: an economy too small to affect the

world real interest rate

World real interest rate (rw): the real interest rate in the international capital market Key assumption: Residents of the small open economy can borrow or lend at the expected world real interest rate

National saving and investment in a small open economy

A small open economy that lends abroad

A small open economy that borrows abroad

 Result: rw may be such that Sd > Id, Sd = Id, or Sd < Id

If rw = r1, then Sd > Id, so the excess of desired

saving over desired investment is lent internationally (net foreign lending is positive) and NX > 0 If rw = r2, then Sd = Id, so there is no net foreign lending and NX = 0 If rw = r3, then Sd < Id, so the excess of desired investment over desired saving is financed by borrowing internationally (net foreign lending is negative) and NX < 0

Saving and Investment in Large Open Economies

Large open economy: an economy large

enough to affect the world real interest rate

Suppose there are just two economies in the world

The home or domestic economy (saving S,

investment I) The foreign economy, representing the rest of the world (saving SFor, investment IFor)
The world real interest rate moves to equilibrate desired

international lending by one country with desired international borrowing by the other

 Equivalent statement: The equilibrium world real interest rate is

determined such that a current account surplus in one country is equal in magnitude to the current account deficit in the other Changes in the equilibrium world real interest rate: Any factor that increases desired international lending of a country relative to desired international borrowing causes the world real interest rate to fall

ECONOMIC GROWTH IN THE OPEN ECONOMY

Small open economies
International trade International finance

Other issues
Trade policies Intellectual property rights Policies toward direct investment Overall macroeconomic climate

PROMOTING GROWTH IN THE OPEN ECONOMY

Best-practice techniques in production processes
Low tariffs and other barriers to trade

Most successful open economies: Europe: Netherlands, Luxembourg Asia: Taiwan, Hong Kong

 Not only physical but also intangible capital Development of intellectual property rights

Stable macroeconomic climate

-taxes are reasonable and predictable and that inflation is low, so lenders need not worry about inflation confiscating their investments.

Low-Risk Country

High-Risk Country

INTERNATIONAL ECONOMIC ISSUES

Two of the central issues that have concerned nations in

recent years: 1. COMPETITIVENESS and PRODUCTIVITY 2. Birth of European Monetary Union

The Deindustrialization of America

During 1980s and later surfaced in the 2000s the

appreciation of dollar produced severe hardships in many US sectors exposed to international trade. COMPETITIVENESS extent to which a nations goods can compete in the marketplace PRODUCTIVITY measured by the output per unit of input

Trends in Productivity
Importance of COMPETITION and OUTWARD

ORIENTATION Theory of Comparative Advantage nations are not inherently uncompetitive HIGH PRODUCTIVITY and HIGH LIVING STANDARDS = expose domestic industries to world markets and encourage them to adopt the most advanced technologies in the world

The European Monetary Union

IDEAL EXCHANGE RATE SYSTEM allows high levels

of predictability of relative prices while stabilizing the economy in the face of economic shocks Fixed exchange rate system subject of intense speculative attacks EU countries took the giant step of linking their economic fortunes through European Monetary Union, which forged a common currency, the Euro.

Toward a Common Currency: The Euro

This economic integration would not only foster economic

ties but also resolve the problem of unstable currencies that plagued the earlier fixed-exchange-rate systems. 11 European countries joined the EMU in 1999, these countries adopted the Euro as their unit of account and medium of exchange. European Central Bank conducts monetary policy for countries in the accord and thereby determine the interest rates for the Euro. PRIMARY OBJECTIVE of ECB: To pursue price stability Price Stability increase in Euroland consumer prices of below 2% per year over the medium term

Costs and Benefits of Monetary Union

BENEFITS Exchange rate volatility will be reduced to zero More efficient allocation of capital across countries Political integration and stability of Western Europe COSTS Individual countries will lose the use of both monetary policy and exchange rates as tools for macroeconomic adjustments OPTIMAL CURRENCY AREA is one whose region have high labor mobility or have common and synchronous aggregate supply or demand shocks The creation of the Euro has removed the intra-European exchange rate movements

FINAL ASSESSMENT
Robust economic performance - It is the period which these countries avoided deep

depression and the cancer of hyperinflation The emerging monetary system - Major economic regions with flexible exchange rate rates, while smaller countries either float or have hard fixed exchange rates The reemergence of free markets - Market-oriented countries of the West prospered while centrally planned command economies collapsed