Lecture Twenty Three
The Open Economy in the Long Run
(Economics 100b; Spring 1996)
Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net
March 20, 1996
Administration
Uncovered Interest Parity and Exchange Rate Volatility
The Trade Balance and Investment
Policies and the Trade Balance
The Long-Run Determinants of the Real Exchange Rate
The Long-Run Determinants of the Nominal Exchange Rate
Administration
Do finish open economy issues by spring break
Begin by running through the topic list for this lecture:
Uncovered Interest Parity and Exchange Rate Volatility
Exchange rates, since the early-1970s breakdown of the Bretton Woods
fixed exchange rate system, have been much more volatile than anyone
had predicted. Why? Here focus on expectations and exchange rate
dynamics.
Suppose that people have a pretty good idea about what the long-run
exchange rate is going to be--call it e*--and notice differences
beween e, the current exchange rate, and e*.expected exchange rate
movements:
Invest in the foreign country, and earn r*
Invest in the home country, and earn r plus or minus the expected
exchange rate movement: e*- e
So that the right equation to go alongside of:
Y = C(Y-T) + I(r) + G + NX(e)
and
M/P = L(i, Y)
isn't r=r*, but is instead:
r = r* + (e - e*)
When e is above e*, the exchange rate is expected to
depreciate, and so domestic real (and nominal) interest rates
will be higher than world market values. When e is below e*,
the exchange rate is expected to appreciate.
Implications?
The higher is the exchange rate e, the higher are domestic interest
rates--and so the LM* curve is upward sloping... It rotates clockwise
around its intersection with the e=e* line... Call this
curve--allowing for expected exchange rate changes and their effects
on domestic interest rates--LM**
The higher is the exchange rate e, the higher are domestic interest
rates--and the lower is investment. So the IS* curve also rotates, in
this case counterclockwise, around its intersection with the e=e*
line. Call this curve--allowing for expected exchange rate changes
and their effects on domestic interest rates--IS**
If the current exchange rate is above e*, then domestic
interest rates will be somewhat higher--and the exchange rate
somewhat lower--than in the static expectations case. If the current
exchange rate is below e*, then the exchange rate will be
somewhat higher--and the domestic interest rate somewhat lower--than
in the static expectations case.
So what happens if there is a sudden decline in the expected long-run
exchange rate because, say, the government has reacted to an increase
in foreign interest rates r* by dropping any plans it might have had
for keeping the exchange rate stable.
The rise in r* pulls the IS* curve down and to the left. And we move
to the IS** curves and LM** curves by rotating the IS* and LM* curves
counterclockwise and clockwise, respectively, around their
intersections with the new e* line.
We find that the current exchange rate e falls, and falls by a
lot--by more than the decline in e*. Why? Well look back at your new
foreign exchange market equilibrium condition:
r = r* + (e - e*)
The whole point of letting e fall was to keep r from having to rise
as much as r*--and to avoid the recession that would come when it
did. So r < r*--which means that e must be lower than e* as
well.
Hence the exchange rate "overshoots": falls more than its long-run
equilibrium value falls, and then slowly climbs back up.
The Trade Balance and Investment
Let's begin with our old-fashioned equation for real GDP:
Y = C + I + G + NX
and note that this holds--as it must if the NIPA is a consistent
accounting system--for both the production and the income sides. Why
does this equation hold? Think of NX = X - M. Every dollar's worth of
commodities first is either consumed C or used in investment I or
bought by the government G or exported X. But C is greater than the
total consumption goods produced in the United States because C also
includes imports of consumption goods. Similarly, I and G include
imports of investment goods and of government purchased goods as
well.
So in order to arrive at the total of goods produced, you have to
subtract imports M from the sum C+I+G+X. Hence:
Y = C + I + G + NX
If we relabel Y = output and C+I+G = domestic spending
We then have:
NX = output - domestic spending
Why is this an interesting equation? It is interesting because a lot
of the public policy debate worries about a trade deficit--about NX
being negative. NX does mean that output is less than domestic
spending--and if we are worried that we are spending "too much" as a
country here in the United States, then a negative trade balance is a
sign that we are spending a lot--more than we produce, in
fact.
For example, at one point--after the complete collapse of health care
reform in the Clinton Administration--the less than competent White
House aide Ira Magaziner somehow got distributed a memo appointing
him to study the causes of the U.S. trade deficit that had grown
steadily through 1993 and 1994 in terms that made it clear that he
imagined that the trade deficit was something that evil foreigners
were doing to us. I had back in my files from early 1993 a memo, in
which I wrote roughly "gee. The Administration isn't doing much to
shrink C (as a share of national product) or G, and is pursuing a
bunch of policies that it hopes will boost I. If these Administration
policies work, then (because the growth rate of potential output is
not that fast) we should be prepared for a large trade deficit in
1994 and 1995 because Y = C+I+G+NX.
Another useful way to rewrite these identities (and all we have been
doing are re-writing identities: things that must be true by
necessity from the definitions of the NIPA components) is to note
that:
Y = C + Sp + T
So:
C + Sp + T = C + I + G + NX
Sp + (T - G) = I + NX
Sp - DEF - I = NX
Take private savings. From it subtract the government's budget
deficit to get national savings. If national savings Sp -
DEF are greater than domestic investment I, then net exports NX will
be positive. If national savings Sp - DEF are less than
domestic investment I, then net exports will be negative.
One way to express this is to say that a trade deficit is a
capital account surplus. If we are importing more than we are
exporting, then foreigners are taking some dollars they earn by
selling us goods and using them to make investments in the United
States--to finance investment. Get rid of the trade deficit by any
means, and you will find that you have reduced I relative to national
savings Sp - DEF as well.
Is a trade deficit a good thing? Depends: do you want I to be more
than, equal to, or less than national savings?
Policies and the Trade Balance
- Fiscal policies that shrink national savings cause a trade
deficit (which, in a large open economy, partly offsets the fall
in investment that comes from expansionary fiscal policy; and in a
small open economy completely offsets it).
- Expansionary fiscal policies abroad (a) crowd out investment
at home (by raising world interest rates), and (b) produce a trade
surplus (as savings in excess of domestic investment flow
abroad to finance investment overseas).
- Mankiw: trade deficit not a problem, but a symptom of a
problem--and perhaps not even that, perhaps good in itself.
The Long-Run Determinants of the Real Exchange Rate
Nominal exchange rate: the relative price of two countries' monies
(or currencies)
Real exchange rate: the relative price of two countries' goods
- Real exchange rate computed from nominal exchange rates and
the price levels in two different countries.
- If the real exchange rate is high, foreign goods are
relatively cheap and domestic goods are expensive--so people try
to buy a lot of foreign goods and less domestic goods, hence trade
deficit.
- If the real exchange rate is low, foreign goods are relatively
expensive and domestic goods are relatively cheap--so people try
to buy a lot of domestic goods and fewer foreign goods, hence
trade surplus.
Wait a minute, you say, I thought that the trade deficit was the
difference between domestic investment and national savings. Now you
say it is the result of spending decisions that depend on the
exchange rate? Which is it?
- The answer is "both"; the real exchange rate moves to make it
so
Draw net exports on the horizontal axis, and the real exchange
rate on the vertical axis. NX(e) is downward sloping. S-I is a
vertical line. Their intersection is the equilibrium real exchange
rate and the equilibrium value of net exports.
- Anything that increases domestic investment relative to
national saving increases the exchange rate
- Anything that decreases domestic investment relative to
national saving reduces the exchange rate.
The Long-Run Determinants of the Nominal Exchange Rate
Nominal exchange rate = real exchange rate * price level abroad/price
level at home
%change in nom. exch. rate = %change in real exch. rate + diff.
between foreign and home inflation rates.
Purchasing power parity...
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