Macroeconomics of the Open Economy
Mankiw: Chapter 14
Would you buy port management services from this man?
Mohammed Sharaf CEO, Dubai Ports World Foreign Direct Investment into the U.S.
Would you borrow money from this man?
Zhou Xiaochuan, Ph.D. Governor, Peoples’ Bank of China Loans to U.S. (China’s central bank buys U.S. govt bonds)
You can download this slideshow at: www. steele-econ.com (If you don’t have PowerPoint, there’s also a link to free software (Open Office) that will play it.
U.S. has net capital inflow from rest of world
NCO – net capital outflow NCO < 0 for previous 25 years Why?
Is this good? Bad?
U.S. NCO: Good or bad?
Basic issue: is it sustainable? Ben Bernanke (Fed): yes – “global savings glut” Nouriel Roubini (NYU): no – America’s “twin deficits”
Why does capital flow into the U.S.? (1)
Needed: an explanation of how trade flows exports, and net capital flows are determined
We’ll see that this comes from an imbalance between U.S. saving and investment
Why does capital flow into the U.S.? (2)
We also need to know the cause and effect mechanisms… What forces govern trade balances and capital flows?
Why does capital flow into the U.S.? (3)
The quick story: NCO = NX = S – I
If S falls, I increases, or both, then NX and NCO both must decrease as well…NCO makes up the difference between S and I
Now … how does this work?
Equality of net exports and net capital outflow
Recall: Net exports = Net Capital Outflow…an accounting identity NX = NCO For the U.S.: Net capital outflow < 0, and Net exports < 0
A macro model of the open economy
Two markets govern: Market for Loanable Funds (LF market) Market for Foreign Currency Exchange (forex market)
Market for Loanable Funds (LF)
Balances national saving S (supply of funds), with Demand for funds, investment I and net capital outflow Recall S = I + NCO
Investment: ACME Industries considers buying new machinery to increase productivity in its factories… will the increased productivity cover the cost of the funds? NCO: Ms. Smith considers purchasing shares on India’s stock market. What’s the cost of using these funds instead of saving?
Private saving: Mr. Roberts considers forgoing consuming some of his disposable income today and saving it… what’s the payoff? Public saving: Federal government runs a budget surplus (saves) or deficit (negative “saving”)
LF market (cont.)
Real interest rate r is the price that equilibrates supply and demand in this market
• Higher r makes saving increasingly attractive, so supply of curve of LF slopes upwards • A higher interest rate makes investment less attractive, and makes foreign assets less attractive, so demand curve slopes downwards
Equilibrium in LF market
If r is above equilibrium level, a surplus quantity of funds is provided – this drives r down If r is below the equilibrium level, there’s a shortage of funds provided, and the interest rate will be driven up r* is the equilibrium real interest rate
Market for Foreign Currency Exchange (forex market)
On this market, dollars (USD) and foreign currencies (e.g. ¥) are traded Real Exchange Rate E is the price that equilibrates demand and supply
Demand and Supply in Forex Market
Recall NCO = NX
• If U.S. has trade surplus, then NX > 0
Americans acquire foreign currency and convert to foreign assets (NCO> 0)
• If U.S. has trade deficit, then NX < 0
Americans acquire more goods than their exports pay for, and so pay with U.S. assets (NCO < 0)
Demand in Forex Market
Demand side: Dollars (USD) are demanded to pay for U.S. net exports NX
A lower exchange rate means U.S. goods are more attractive (since it takes fewer units of foreign currency to buy a dollar), so curve slopes down
Supply in Forex Market
Supply side: supply of dollars comes from NCO (e.g. Smith buying Indian stock shares)
Since NCO depends on interest rate r, not exchange rate E, the supply curve is vertical
Equilibrium in forex market
E*…the exchange rate that coordinates demand and supply Note that this equilibrium rate is a mechanism coordinating NX and NCO
Putting it all together Note that NCO is a factor in both the Loanable Funds market and Forex market – it links the two
• To buy an asset abroad, finance it in LF market • To buy an asset abroad, supply USD in forex market
Equilibrium: both markets
Loanable funds market – equilibrium interest rate Forex market – equilibrium exchange rate These balance S, I, NX, NCO
Example: America’s twin deficits
1. Low saving and government budget deficits in U.S. 2. Upward pressure on interest rates boosts capital inflow from abroad (NCO lower) 3. This cause U.S. dollar to appreciate; so NX fall
Twin deficits (cont.)
U.S. saving < U.S. investment we borrow abroad (NCO < 0) Hence “strong dollar” makes U.S. goods less attractive to foreigners, and foreign goods more attractive to Americans (NX < 0)
Example: Capital flight and instability
What causes currency crises? (e.g. Mexico 1994-5, East Asia & Russia 1998…
Possibly U.S.? – 200? (Roubini’s fear)
Example: Capital flight
Suppose international investors decide that a country’s economic (or political) situation has become unsustainable (Roubini – what if Asian central banks decide that the U.S. has overextended itself, borrowed too much?)
Capital flight (cont.)
1. Investor concerns lead to increase in NCO (move capital to safer markets) 2. Demand for funds to buy foreign assets increases, drives up r 3. More domestic currency supplied in forex market, domestic currency depreciates
Capital flight (cont.)
Results: Interest rates rise (reduces investment and growth) Domestic currency depreciation causes NX to rise
• Russia 1998 – foreign firms fled, imports fell drastically • After turmoil settled, many Russian firms saw domestic sales and exports improve dramatically
Could this happen in U.S.?
Argument against – U.S. is a safe haven, very productive, and world has excess saving… hence we should expect NCO < 0 It’s sustainable
Could this happen in U.S.?
Argument for: A large share of capital inflows into U.S. are from (e.g. China) If Asian Central Banks decide U.S. is overexposed, or China decides to allow its own currency to appreciate, then U.S. might experience a reduced capital inflow sufficient to cause Americans pain…maybe a lot
Truth likely is between the extremes Don’t count on the end of the world, but… Low saving and continued federal deficits deserve attention
For additional info, see
“The Overstretch Myth” Foreign Affairs Mar/Apr 2005
“How Scary is the Deficit?” Foreign Affairs Dec 2005