ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

The Classical Model in the Open Economy

1. The Goods Market Equilibrium (Open Economy) Recall that in the classical model in the closed economy: o Supply side: the labor market reaches the full employment and therefore the economy produces its potential output automatically in the long run. o Demand side: the loanable funds market clears, which ensures that the total leakages are equal to the total injections. Therefore, Says law hold and domestic demand equals to domestic output supply (goods market equilibrium). The key difference between open and closed economy is that, in an open economy, a countrys domestic spending need not equal its output. The planned expenditure in the open economy:
E p C I p G NX

In an open economy, the goods market is in equilibrium when the supply of output (i.e. potential GDP) equals total demand for output (planned expenditure):
Y C I p G NX

Y (C I p G) NX

In an open economy, domestic demand need not equal the supply of output. o If output exceeds domestic planned expenditure, the country exports the difference, NX > 0. o If output falls short of domestic planned expenditure, the country imports the difference, NX < 0. Therefore, the goods market equilibrium condition can be rewritten as:
S T M I p G X

o o

The left hand side (S + T + M) is the leakages out of households spending. The right hand side (Ip + G + X) is the injections.

The goods market will be in equilibrium if and only if total leakages are equal to total injections. o What is the mechanism that ensures leakages = injections in an open economy?

2. The Loanable Funds Market in an Open Economy As in the closed economy, the goods market and the loanable funds market are closely related. In an open economy, the goods market equilibrium condition can be written as:
S I p (G T ) NX S [ I p (G T )] NX

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

The left hand side of the equation is the difference between household saving, i.e. domestic supply of loanable funds and the firms planned investment expenditure plus government budget deficit, i.e. domestic demand for loanable funds. What would happen when the economys supply of loanable funds exceeds its demand? Net capital outflow is the amount that domestic residents are lending abroad (say by buying foreign bonds or other financial assets), i.e. net foreign lending. The right hand side of the equation is the net export, which is also called trade balance. Trade surplus, when NX > 0. Trade deficit, when NX < 0. Balanced trade, when NX = 0.

When a country runs a trade surplus, there is an excess supply in the domestic loanable funds market, resulting in a net capital outflow (lending to foreigners) equal to its trade surplus. o What is the intuition behind? Suppose that an American sells an exported an iPhone to a Japanese consumer for 20,000 yen. The transaction increases U.S. NX. But what will the exporter do with the 20,000 yen received? o Buy Japanese goods o Buy Japanese financial assets such as Japanese bonds. o Trade the Japanese to a bank for US dollars. The bank may sell the Japanese yen to another U.S. resident for the purpose of buying Japanese goods or financial assets. The bank may also sell the Japanese yen to the central bank, which will increase the central banks foreign exchange reserves (in forms of holding foreign assets). In any case above, it ensures that net capital outflow equals to net exports. o What if the country runs a trade deficit?

3. The Loanable Funds Market Equilibrium To show how loanable funds market is related to international trade and lending or borrowing, we examine the case of small open economy with perfect capital mobility. o Small economy refers to an economy that is a small part of the world loanable funds market and therefore cannot affect the world interest rate. o Perfect capital mobility means that residents have free access to world financial markets. For a small open economy with perfect capital mobility, the real interest rate in our small open economy must equal to the world real interest rate, rw. o The world interest rate is determined by the total demand and supply of loanable funds market in the world. What would happen if rw > r* (domestic equilibrium real interest rate)? What if rw < r*?

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Real interest rate (r) Foreign lending = NX (>0) r

w

[Ip + (G T)] Ip + (G T) S Loanable Funds

Real interest rate (r) S

Foreign borrowing = NX (< 0)

[Ip + (G T)] Loanable Funds

Ip + (G T)

In an open economy, domestic supply of loanable funds need not equal domestic demand in equilibrium. Notice that when the loanable funds market is in equilibrium in an open economy, i.e. S [Ip + (G T)] = NX, it implies: S T M I p G X That is, the goods market will also be in equilibrium as the total leakages are equal to total injections, which ensures Says law to hold in an open economy.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

4. Fiscal Policy For a small open economy, an increase in government spending (for a country with trade surplus) will not affect world interest rate, but will result in a decrease in net export. This is the reason why many economists suggest that the government budget deficit may be the primary cause of the trade deficits. o The phrase twin deficits conveys the idea that the government budget deficit and the trade deficit are closely linked.

Real interest rate (r) Foreign lending = NX (>0) S r

w

[Ip + (G T)]2 [Ip + (G T)]1 Ip + (G T) S Loanable Funds

What would you expect to be the impact of an increase in budget deficit for a large open economy (for which its demand or supply for loanable funds is large enough to affect the world loanable funds market, thus world interest rate)?

Readings: Chapter 20 Appendix: The Appendix is a much simplified version (in some parts misleadingly simplified) of the analysis of the classical model in the open economy.

America relies on foreigners to finance much of what it buys. Therein lies the principal threat to the IMFs projections: will the rest of the world, principally East Asia, continue to finance Americas trade deficit, and, if not, how will that deficit unwind? Will it close via a welcome rise in foreign demand, an unwelcome fall in American demand, or through a realignment of currencies, switching demand towards American goods and away from the goods of its trading partners?

Growing economies, gaping deficits

The world economy is recovering its strength, but not its balance
Sep 19th 2003 | from the print edition

THE International Monetary Fund (IMF) enters its annual meeting in Dubai this weekend expecting the world economy to grow by 4.1% next year. The IMF issued the same projection in April, but five months down the road, with the Iraq war over, deflation at bay, and economies finally responding to macroeconomic policy, the prediction can be held with more confidence. The threats to world growth have recededthough they have not disappeared. Much of this renewed confidence is inspired by Americas gathering momentum. But the countrys surprisingly strong recovery in the second quarter was eclipsed, even more surprisingly, by Japans. Japan grew by 3.9% in the quarter (at an annualised rate), America by 3.1%. The IMF has duly revised upwards its growth projection for Japan, but at 1.4% for 2004, it still looks conservative compared, for example, with the 2.6% growth predicted by J.P. Morgan. Nonetheless, the guiding theme of the IMFs outlook on the world economy remains correct: America is still the main motor of global growth. If the Japanese economy has four cylinders, America has ten: growth of 3% in Americas vast ten-trillion-dollar economy adds much more to world output than 3% growth in Japans four-trillion-dollar economy. Besides, Japan tends to follow the world economy, not lead it. It relies on foreigners to buy much of what it produces, whereas

American demand, of course, has already fallen from the heady peaks of the last decade. But the current-account deficit has continued to widen. Why? In so far as the private sector has slowed its spending (and households have not slowed much), the American government has taken over. The IMF forecasts a deficit of over 6% of GDP this year in the combined federal and state budgets. Over half of Americas impressive second-quarter growth was driven by military spending. The United States has the best recovery that money can buy, said Kenneth Rogoff, the IMFs chief economist. Who is financing Americas overspend? The foreign investors, many of them European, who used to buy up American equities have largely withdrawn. Asian central banks, buying American Treasuries and agency debt, have taken their place. Asia holds about $1.66 trillion in foreign-exchange reserves, most of them in dollar assets. If Americas twin deficits, a current-account deficit matched by a budget deficit, are reminiscent of the 1980s, the rapid accumulation of dollars in foreign capitals is somewhat reminiscent of the slow demise of the Bretton Woods era in the late 1960s and early 1970s. The appetite of Asian creditors for American assets is preventing the broad weakening of the dollar that the IMF and many in America would like to see. From its peak in early 2002 to mid-May, the dollar fell by a modest 12% in trade-weighted terms. Exports have begun to respond, with volumes growing by more than 20% over the past three months. But some reckon the dollar would have to fall by as much as half to get Americas current-account deficit back under control. Can the dollar fall again? The euro has borne the brunt of its fall so far, appreciating by 20% against the dollar since early 2002. Indeed, a strengthening euro is slowing recovery in Europe, according to the IMF. Exports have led Europe out of previous recessions; but their pull has been weak this time round. In previous recoveries, by this stage euro members would expect their exports to have grown by over 13% from

their lows. But they have grown by less than 10%. The IMF cautions the European Central Bank (ECB) to stand ready to cut interest rates again if the euro strengthens further. Inflation across the euro area as a whole is a healthy 2.1%, slightly above the ECBs ceiling. But if that average disguises near-deflation in Germany, it may not be the best guide to ECB policy, the IMF warns. Japan is also worried about the falling dollar. Its monetary authorities spent $78 billion between January and August this year selling yen and buying dollars. The IMF supports Japans strategy of holding the yen down as a way to reflate its economy, but not everyone is so sympathetic. On Thursday, just days before Japans finance minister was to meet the other leaders of the G7 economies in Dubai, the yen strengthened to under 115 to the dollar for the first time in two-and-ahalf years. Some speculate that Japan is letting the yen appreciate to deflect criticism of its weak yen policy at this weekends meetings. Japan will not be the only country whose exchange rate is in the spotlight at Dubai. China, not yet a member of the G7, is nonetheless a favourite topic of conversation. As the dollar has weakened, Chinas yuan has tracked its fall. China is now running a conspicuous trade surplus with America at a time when the latter is fast losing manufacturing jobs. John Snow, Americas treasury secretary, visited Beijing this month to impress upon China the case for loosening its currency peg of 8.3 yuan to the dollar. He and other finance ministers will likely repeat this call in a planned unofficial meeting with Chinese officials on the margins of the G7 meeting. To appease Mr Snow, China might soften its peg slightly, allowing the yuan to bobble within a slightly wider band. But that will not be enough to realign the dollar, let alone to halt the tectonic shifts going on in the geography of manufacturing employment. To make a real difference to the dollar, according to recent calculations by Goldman Sachs, the yuan would have to appreciate by 15% and other Asian currencies would have to follow suit. That is about as likely as Snow descending on Dubai.
from the print edition

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