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Econ 100b

Created 4/30/1996
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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


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

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?

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.


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...


>

Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page


Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/