曼昆第10版讲义mankiw10e-irm-ch06

|CHAPTER6 TheOpenEconomy

LectureNotes|

CHAPTER6

TheOpenEconomy

NotestotheInstructor

ChapterSummary

Thischapterintroducesasimplemodelofasmallopeneconomyinthelongrun.Themainaimsofthechapterareasfollows:

Toacquaintstudentswiththeterminologynecessaryforunderstandingtheopeneconomy.

Toprovideasimplemodelofinternationalflowsofcapitalandgoods,emphasizingthattheseultimatelydependuponthedeterminantsofsavingandinvestment.

Topresentasimplemodeloftherealexchangerate,emphasizingitsroleinensuringthatthecurrentaccountandthecapitalaccountsumtozero.

Toexplainthedeterminationofthenominalexchangerate.

Comments

Studentsareinterestedintheopeneconomy;thischapterprovidesthemwithtoolstothinkaboutopeneconomyissues.Iemphasizethefactthatwecanfigureoutthetradebalancebeforeweintroducetheexchangerateintotheanalysis.Thisisoftensurprisingtostudents.Thechapteralsocontainsadiscussionofprotectionism,thusallowingthepresentationofanothersurprisingresult:protectionistpoliciesdonotimprovethetradebalance.Thesetwofindingsdrivehometheimportanceoffinancialflowsinananalysisoftheopeneconomy.

Thechapterhasthepotentialtobeconfusingtostudentsinseveralways.Onedifficultyisgettingthesignsrightinanalyzingthecapitalandcurrentaccounts.Itisworthgoingthroughsomeexamplesofspecificinternationaltransactionstohighlighthowthesetransactionsgiverisetoeitherpositiveornegativeentriesintheaccounts.Aseconddifficultyisinterpretinghowtheexchangerateisquoted.Iemphasizethatthetextbookexpressesexchangeratesintermsofforeigncurrencyperdomesticcurrencyunit.Hence,appreciationanddepreciationofthedomesticcurrencyarerepresentedbyincreasesanddecreases,respectively,intheexchangerate.Ialsostressthattheexchangerateisamarket-determinedprice,determinedbytheintersectionofthenetsupplyofdollars(S–I)andthenetdemandfordollars(NX).

Anotherpotentialdifficultyforstudentsistheshiftfromtheclosedeconomytothesmallopeneconomy.Iemphasizetheadvantagesofusingdifferentmodelstoanswerdifferentquestionsandexplainthatthelargeopeneconomyrepresentssomekindofaverageofasmallopeneconomyandalargeclosedeconomy.InotethatwecancombinethetwomodelstoobtainamorecomplicatedmodelthatdoesapplymoredirectlytotheUnitedStates.Timepermitting,itisworthgoingthroughthelargeopeneconomycasetodrivehomethepointthatwearenotmisledbycombiningtheconclusionsfromtheclosedeconomyandsmallopeneconomycases.

Becauseofthesubtletiesanddifficultiesoftheanalysis,thematerialinthischapterrequirestwoorthreelectures.

UseoftheWebsite

Asahardbutworthwhileexercise,studentscouldbeaskedtocombinethemodelsofChapters3and6tounderstandthelargeopeneconomy.AgoodstartingpointistosupposethattheUnitedStatesishalftheworldeconomyandtothinkaboutChapter3asamodeloftheworldeconomy.Nowsuppose,forexample,thatgovernmentspendingisincreasedby$200billion.Thisislikeanincreaseof$100billionintheworldeconomy.TheChapter3modelcanbeusedtofigureouttheimpliedriseintheworldinterestrate.TheChapter6modelcanthenbeusedtoinfertheimplicationsforU.S.investment,netexports,andtheexchangerate.Theweb-basedsoftwarecanalsobeusedtoconsidertheimplicationsofpurchasingpowerparitybysettingtheexchangeratesensitivityofnetexportstoalargenegativenumber.

UseoftheEWebsite

GototheEwebsiteanddownloadannualdatasince1973fortheU.S.dollarexchangerateagainsttheJapaneseyen,theBritishpound,andtheCanadiandollar.Now,downloaddataontheconsumerpriceindex(CPI)fortheUnitedStates,Japan,UnitedKingdom,andCanada.ComputerealexchangeratesbymultiplyingtheforeigncurrencypriceofadollarbytheCPIfortheUnitedStatesandthendividingbytheCPIoftherespectivecountry.Discusshowtherealexchangerateshavechangedovertime.Someeconomistsarguethatrealexchangeratesshouldtrackproductivitydifferencesbetweencountriesoverlongperiodsoftime.Downloaddataonlaborproductivityforthefourcountries.ComputerelativeproductivityfortheUnitedStatesbydividingitsproductivityindexbytherespectiveindexesfortheothercountries.Assesswhethermovementsintherealexchangeratecapturetrendsinrelativeproductivitylevels.

ChapterSupplements

Thischapterincludesthefollowingsupplements:

6-1 TheTerminologyofTrade

6-2 SavingandInvestmentinOpenEconomies

6-3 TheOpenEconomyintheVeryLongRun

6-4 TourismandtheExchangeRate

6-5 TheExchangeRateandtheInflationRate(CaseStudy)

6-6 CoveredInterestParity

6-7 Purchasing-PowerParityandRealExchangeRates

6-8 MoreontheBigMacandPPP(CaseStudy)

LectureNotes

Introduction

Wenowhaveanearlycompletepictureofthemacroeconomyinthelongrun.Outputisdeterminedbycapital,labor,andtechnology.Thepriceleveldependsonthemoneysupply,andtheinflationrateisdeterminedbythegrowthrateofthemoneysupply.Wehaveexplainedthelong-rundeterminationofseveralofthevariablesthatinterestmacroeconomists,andwehavedevelopedsomeunderstandingofhowgovernmentpoliciesaffecttheeconomy.Buttwoimportantpartsofthepicturearestillmissing:wehavethusfarignoredconsiderationsofinternationaltradeandreasonsthatunemploymentoccurs.Inthischapter,weaddressinternationalaspectsofthelong-runmodelandleavequestionsaboutunemploymentuntilChapter7.

Thefirstandmostimportantpointisthatvirtuallyalleconomiesareintegratedintoalargerworldeconomy.Economiesdonotexistinisolationbuthaveextensivetradingrelationswiththerestoftheworld.Economiesthattradewithothereconomiesarecalledopeneconomies.IntheUnitedStatesin2010,forexample,exportswere$1,840billionandimportswere$2,357billion(13percentand16percentofGDP,respectively).Inothercountries,internationaltradeisevenmoreimportant.

Figure6-1

Duringthelate1990sandearly2000s,theUnitedStatesdevelopedasubstantialtradedeficit;thatis,importsexceededexports,sonetexportsbecameverynegative.Inthemid-1990s,theUnitedStatesranamodesttradedeficit.Butbetween1996and2006,GDProseby71percent,whiletotaldomesticspending(C+I+G)roseby79percent.TheUnitedStatesasawholeconsumedmorethanitproduced.Likeanindividualwhoconsumesinexcessofherincome,thecountryasawholewaslivingbeyonditsmeans.Tofinancethisdeficit,theUnitedStateshadtoborrowfromtherestoftheworld.

Thissuggestsanimportantpoint:thereisacloserelationshipbetweenflowsofgoodsandservicesbetweennationsandfinancialflowsbetweennations.Understandingthisconnectionisourfirsttaskinexplainingmacroeconomicsinanopeneconomy.Wethenaddthiscomplicationintoourbasicmodelofincomedetermination.Finally,wemovetoatheoryoftheexchangerate.

6-1 TheInternationalFlowsofCapitalandGoods

TheRoleofNetExports

Inanopeneconomy,wehavetoreviseourbasicnationalincomeidentitytoread

Y=C+I+G+NX,

whereNX=netexports=exportsminusimports.Netexportsisthedifferencebetweenoutput(Y)anddomesticspending(C+I+G).Rememberthatthisequationistheequilibriumconditionforthegoodsmarket:thesupplyofgoodsequalsthedemandforgoods.ButifconsumersintheUnitedStatesdemandToyotasorifU.S.firmspurchaseprecisiontoolsmanufacturedinGermany,thatdoesn’ttranslateintoademandforU.S.goods;hence,wemustsubtractimportsfromspending.Conversely,exportsrepresentthedemandforourgoodsbycitizensofothercountriesandsoareasourceofdemandnotincludedindomesticspending.

InternationalCapitalFlowsandtheTradeBalance

Table6-1

Ouranalysisoftheclosedeconomyemphasizedthatsavingequalsinvestment.Thesameistrueintheopeneconomyifweexpandourdefinitionofsavingtoincludesavingbyothercountries.Startingfrom

Y=C+I+G+NX

andrecallingthatS=Y–C–G,weget

S–I=NX.

Theright-handsideofthisidentity,netexports,issometimesreferredtoasthetradebalance.Whenexportsareequaltoimportswesaythatthetradebalanceequalszero(orthat“tradeisbalanced”).Whenexportsexceedimportswehaveatradesurplusandwhenexportsarelessthanimportswehaveatradedeficit.

Supplement6-1,“TheTerminologyofTrade”

Theleft-handsideofthisidentityistheexcessofdomesticsavingoverdomesticinvestmentandrepresentsthenetamountwearelendingtoforeigners.Thisnetamountoflendingiscallednetcapitaloutflowbecauseitreflectstheoutflowoffundsfromourcountry.Whenthedomesticsavingfallsshortofdomesticinvestment,wemustborrowfromabroadtofinancethedifferenceandwerefertothisasnegativenetcapitaloutflow.

Thus,thenationalincomeaccountsidentityillustrateshowtheinternationalflowoffundstofinancecapitalaccumulationandinternationaltradeingoodsandservicesaretwowaysoflookingatthesamequestion.Whensavingisgreaterthanneededtofinanceinvestment,welendtheexcesstoforeigners.Foreignersusethisloantopurchasemoregoodsandservicesfromusthanwepurchasefromthem;werunatradesurplus.Alternatively,whenweinvestmorethanoursavingallows,weborrowfromforeignerstomakeupthedifference.Thisborrowingallowsustopurchasemoregoodsandservicesfromforeignersthantheypurchasefromus;werunatradedeficit.

Internationalcapitalflowscantakemanydifferentforms.Thesemaybeloanslikethosewe’vedescribedormayinvolvethepurchaseofassets,suchasfactories,equities,orrealestate.Regardlessofwhetherforeignersarepurchasingdebt(makingloans)orpurchasingassets,theyaregainingclaimsonthefuturereturnstoourcapital.

InternationalFlowsofGoodsandCapital:AnExample

Netexportsmustalwaysequalnetcapitaloutflowbecausethisrelationshipisanidentity.Theintuitionbehindthisrelationshipinvolvestracingoutthemovementofmoneyinaseriesoftransactions.TheexampleinthetextbookinvolvesBillGatessellingacopyoftheWindowsoperatingsystemtoJapanandconsidersthesetoftransactionsthatMr.Gatescouldmakewiththeproceedsofthesalethatmustalwayssatisfytheidentity.

TheIrrelevanceofBilateralTradeBalances

Thedifferencebetweensavingandinvestmentdeterminesacountry’soveralltradebalancebutdoesnotdetermineacountry’sbilateraltradebalancewithanygivencountry.Alargedeficitwithsomecountriesmaybematchedbylargesurpluseswithothercountries;so,overall,exportsandimportsareequal.

6-2 SavingandInvestmentinaSmallOpenEconomy

CapitalMobilityandtheWorldInterestRate

Whenanalyzinganopeneconomy,weobviouslycannolongerrestrictourattentiontodomesticvariables.Inparticular,worldinterestratesbecomecentraltotheanalysis,raisingtheissueofwhetherornotsuchvariablesareindependentofwhatgoesoninthedomesticeconomy.Ifweareanalyzingtheeconomyof,say,Iceland,itisprobablyreasonabletosupposethatchangesintheIcelandiceconomyhaveanegligibleeffectonworldinterestrates.Suchaneconomyisreferredtoasasmallopeneconomy.ItislessevidentthatthisisanappropriateassumptionforalargeopeneconomyliketheUnitedStates.Nonetheless,wefirstconsiderthebehaviorofasmallopeneconomyandlatershowthattheappropriateanalysisforalargeopeneconomyliessomewherebetweenthesmallopeneconomymodelandtheclosedeconomymodelthatwehavealreadyconsidered.

Thekeynewassumptionisthattheinterestrateinasmallopeneconomyisnotdeterminedbydomesticsavingsandinvestmentbutratherissetattheprevailingworldlevel(r=r*).Suchanassumptionpresupposesthatconsumersandfirmscanfreelyborrowandlendininternationalfinancialmarkets.

WhyAssumeaSmallOpenEconomy?

Weusetheassumptionofasmallopeneconomytosimplifytheanalysis.Ourintentistobuildabasicmodelthatcapturesthemostimportantfeaturesoftheeconomywhileignoringadditionalcomplications.Forsomecountries,thisassumptionismorelikelytoberealisticthanothers.InthecaseoftheUnitedStates,theempiricalapplicationoftheframeworkwouldrequiremodifyingthemodeltoallowforeffectsonworldinterestratesresultingfromshiftsinsavingandinvestment.Theappendixtothischapterprovidessuchamodelofthelargeopeneconomy.

TheModel

Apartfromtheassumptionthatr=r*,themodelcloselyresemblesourearlieranalysis.Asbefore,wewillletY=,C=C(Y–T),andI=I(r)andtakegovernmentpolicy(GandT)asexogenous.TheclassicalmodelpresentedinChapter3showedthatsavingisthenalsoexogenous().Thelevelofinvestmentisdeterminedsimplybytheinvestmentfunctiongiventheworldinterestrate[I(r*)].Combiningthesewiththeaccountingidentitythatsetsnetexportsequaltonetcapitaloutflow,weobtain

NX=–I(r*).

Figure6-2

Netexportsaredeterminedasaresidual.Ifdomesticsavingexceedsdomesticinvestmentattheworldinterestrate,netexportswillbepositive.

Butwhatensuresthatothercountrieswillborrowfromorlendtousinsuchawaythatnetcapitaloutflowequalsthetradebalance?Theanswerisavariablethatwehavethusfarignored—theexchangerate.Forthepresent,wecontinuetoleaveexchangeratesoutofthepicture;wecomebacktothemlater.

Supplement6-2,“SavingandInvestmentinOpenEconomies”

HowPoliciesInfluencetheTradeBalance

Thismodelpermitseasyanalysisoftheeffectsoffiscalpolicyinanopeneconomy.Ifthegovernmentincreasesspendingorcutstaxes,then,justasintheclosedeconomymodel,nationalsavingfalls.Iftheeconomystartsinapositionoftradebalance(NX=0),thentheconsequenceisatradedeficitandnegativenetcapitaloutflowsincethereisnowinsufficientdomesticsavingtofinancedomesticinvestment.

Figure6-3

Wemightalsobeinterestedintheconsequencesofchangesinthefiscalpoliciesofothercountries.Tounderstandthese,wemustgobacktoourclosedeconomyanalysis.Sinceweareconsideringaneconomythatisnegligibleinworldmarkets,wecanviewtherestoftheworldasaclosedeconomy,whichmeansthatifthereisanincreaseinspendingbytherestoftheworld,theworldinterestratewillrise.Fromtheperspectiveofthesmallopeneconomy,thisincreaseintheworldinterestrateisexogenous.Itleadstoafallindomesticinvestment.Startingfromtradebalance,theconsequenceofthefiscalexpansionabroadispositivenetcapitaloutflowandatradesurplus.

Figure6-4

Figure6-5

Finally,considertheconsequencesofgovernmentpoliciesdesignedtoencourageinvestmentinasmallopeneconomy.Thesewouldimplythattheinvestmentfunctionwouldshiftoutsincefirmswouldwishtocarryoutmoreinvestmentattheworldinterestrate.Sincedomesticsavingisunchanged,thisextrainvestmentwouldhavetobefinancedbyborrowingfromabroad,implyingatradedeficit.

EvaluatingEconomicPolicy

Tradedeficitsarisewhenthereisinsufficientdomesticsavingtofinancedomesticinvestment.Lowlevelsofsavinginaneconomyareanalogoustolowlevelsofsavingbyanindividual;theyimplythatconsumptioninthepresentishighattheexpenseofconsumptioninthefuture.Inaclosedeconomy,lowlevelsofsavingresultultimatelyinalowcapitalstock,asshownbytheSolowgrowthmodeldiscussedinChapters8and9.Inanopeneconomy,lowlevelsofsavingleadtoagrowingforeigndebt.

Supplement6-3,“TheOpenEconomyintheVeryLongRun”

Justasitissometimesdesirableforanindividualtobeaborrowerratherthanasaver,soitisnotnecessarilythecasethattradedeficitsarebadforacountry.Theymay,forexample,reflectborrowingtofinancehighlevelsofinvestmenttopromotedevelopment.

CaseStudy:TheU.S.TradeDeficit

Figure6-6

ThesmallopeneconomymodelcanhelpusunderstandtheevolutionoftheU.S.tradedeficitduringthe1980s,1990s,andearly2000s.Byusingtheidentitythatnetexportsequalthedifferencebetweensavingandinvestment,wecananalyzethecombinationofmovementsinsavingandinvestmentthatgaverisetothetradedeficitduringthisperiod.Inthe1980s,thedeficitincreasedsharplyatthesametimethatnationalsavingdeclinedduetotheriseinthefederalbudgetdeficit.Thisemergenceofsimultaneousdeficitsinbothtradeflowsandthegovernmentbudgethasbeenreferredtoasthetwindeficits.Afterfallingsharplyatthestartofthe1990s,duetoadropininvestmentastheeconomywentintorecession,thetradedeficitonceagainincreasedsharply,hittingarecordbothindollartermsandasashareofGDPbytheyear2000.Unlikeinthe1980s,thegovernment’sbudgetdeficitwasshrinkingduringthe1990sandeventuallymovedintosurplus,leadingtoariseinsaving.Investment,however,surgedfasterthansaving,probablyreflectingtheinformationtechnologyboom.Becauseinvestmentgrewmuchmorethansaving,thetradedeficitexpandedsharply.Intheearly2000s,ashiftinfiscalpolicyfrombudgetsurplustobudgetdeficitlowerednationalsavingandledtoafurtherwideninginthetradedeficit.Theshiftinfiscalpolicyoccurredastheresultoftaxcuts(in2001and2003)andincreasedgovernmentspending(thewarsinAfghanistanandIraqaswellasnewmeasuresforhomelandsecurity).NationalsavingfelltoanhistoriclowasashareofGDPandthetradedeficitreachedrecordhighs.

Afewyearslater,adeclineinhousepriceswasaccompaniedbyareductioninthetradedeficit.Theweakhousingmarketleddirectlytoapullbackinresidentialinvestmentandalsoloweredhouseholdwealth,therebyinducingariseinpersonalsaving.Withinvestmentfallingandsavingrising,thetradedeficitfellfrom5.8percentofGDPatitspeakin2006to3.6percentin2010.

CaseStudy:WhyDoesn’tCapitalFlowtoPoorCountries?

TheU.S.tradedeficitisfinancedbytheflowofcapitalintotheUnitedStatesfromforeigncountries.ButmanyofthecountrieswithtradesurplusesaremuchpoorerthantheUnitedStates,andsoonewouldexpectthattheywouldbeborrowersratherthanlenders.Furthermore,ifcapitalisscarceinpoorcountries,thenthemarginalproductofcapitalshouldbehigh,comparedtorichcountrieswherecapitalisabundant.Onewouldexpectthatahighmarginalproductofcapitalinpoorcountrieswouldattractcapitalinflows.

Toexplaintheseemingparadoxofwhycapitaldoesn’tflowtopoorcountries,weneedtorecognizethatthemarginalproductofcapitaldependsnotonlyontheamountofphysicalcapitalavailabletoaneconomy,butalsoontechnologyandhumancapital.Ifpoorcountrieshavelessaccesstoadvancedtechnologiesandlowlevelsofeducation,thenthemarginalproductofcapitalmayactuallybequitelow.Inaddition,poorcountriesoftenhaveweakornonexistentinstitutionsforenforcingpropertyrights.Thiscanmakeinvestmentmorerisky—bothfordomesticsourcesandforeignsourcesofcapital.Thesehypothesescouldexplainwhycapitalflowsoutofpoorcountriestowardrichcountries.

6-3 ExchangeRates

Ournexttaskistoexplaintheexchangerate.Here,itisimportanttobeclearondefinitions.

NominalandRealExchangeRates

Thenominalexchangerate(e)denotestheamountofforeigncurrencythatcanbeboughtwith$1.Equivalently,itisthepriceofadollarintermsofforeigncurrency.Thevalueofeisdeterminedinamarket—themarketforforeignexchange.Notethatsincethenominalexchangerateisthepriceofonecurrencyintermsofanother,itcanbequotedintwoways.Ifeisthepriceofadollarintermsof,say,theSwissfranc,then1/eisthepriceofaSwissfrancintermsofdollars.Newspapersgenerallyreportexchangeratesintwoways:asdollarsperforeigncurrencyunitandasforeigncurrencyperdollar.Whentheforeigncurrencyvalueofthedollarrises(i.e.,thedollarbuysmoreofaforeigncurrency),wedescribethatasanappreciation,orstrengthening,ofthedollar.Andwhentheforeigncurrencyvalueofthedollardeclines,wedescribethatasadepreciation,orweakening,ofthedollar.

Exchangeratescanbefloating,fixed,orsomewherebetweenthetwo.Floatingmeansthattheexchangerateisdeterminedbydemandandsupplyincompetitivemarkets.Fixedmeansthatthemonetaryauthoritiesfixthevalueofebystandingreadytobuyandselldollarsatthatrate.Managedfloatingissomewherebetweenthetwo.TheU.S.dollariscurrentlyfloating,thoughtheU.S.monetaryauthoritiesdosometimesinterveneinforeignexchangemarkets,buyingandsellingthedollarinattemptstoinfluenceitsvalue.WereturntofixedexchangeratesinChapter13;forthepresent,werestrictourattentiontofloatingexchangerates.

Inreality,ofcourse,therearemanyexchangerates(dollar–yen,dollar–euro,euro–yen,etc.).Wefocusononeforsimplicity,andsothinkabouttheUnitedStatesastradingwithanamorphousrestoftheworld.Theexchangeratecanbethoughtofastradeweighted—someaverageoftheexchangerateswithallourtradingpartners,withmoreweightplacedonthosecountrieswithwhichwetradealot.

Ifwemultiplythenominalexchangeratebytheratioofdomestictoforeignpricelevels,weobtainameasureknownastherealexchangerate.Therealexchangerateistherelativepriceofdomesticgoodsintermsofforeigngoods.Inotherwords,itequalstheamountofforeigngoodswecanpurchasebygivingupaunitofdomesticgoods.Wecalculatetherealexchangerateasε=eP/P*.Whentherealexchangerateishigh,foreigngoodsarerelativelycheapanddomesticgoodsarerelativelyexpensive.Theoppositeistruewhentherealexchangerateislow.

TheRealExchangeRateandtheTradeBalance

Figure6-7

Supplement6-4,“TourismandtheExchangeRate”

Netexportsdependupontherealexchangerate.Ifthedollarismorevaluable,importsarerelativelycheaperandexportsaremoreexpensive.Increasesintheexchangeratethustendtodecreasenetexports.WethuswriteNX=NX(ε).

TheDeterminantsoftheRealExchangeRate

Figure6-8

Therealexchangerateadjuststoensurethatnetexportsequalthedifferencebetweendomesticsavinganddomesticinvestment(netcapitaloutflow).Weknowthat

NX(ε)=–I(r*).

SinceSisfixedatandrisfixedatr*,thenεmustadjusttoensurebalance.

Wenotedearlierthattheexchangerateisultimatelydeterminedinthemarketforforeignexchange.Whenweexporttoforeigners,theyneedtoacquireU.S.dollarstopurchaseourgoods.Whenwewishtoimportgoods,weselldollarstogetothercurrencies.Ifweexportmorethanweimport,thenforeignerswillneeddollarsinadditiontotheonestheygetfromourpurchaseofimports.Sopositivenetexportscorrespondtoanetdemandfordollarsbyforeigners.Thenetcapitaloutflow,meanwhile,representstheavailabledollarsforlendingabroad.Inequilibrium,thesupplyofdollarsfromthenetcapitaloutflowequalsthedemandfordollarsbyforeignerspurchasingournetexports.Theexchangerateadjuststobringaboutequilibriumofsupplyanddemand.

HowPoliciesInfluencetheRealExchangeRate

Figure6-9

Earlier,welookedattheeffectsofvariouspoliciesonnetexportsandnetcapitaloutflow.Wecannowconsiderhowthosepoliciesaffecttheexchangerate.First,consideranexpansionaryfiscalpolicy,whichreducesnationalsaving.Thisreducesnetcapitaloutflow,thusreducingthesupplyofdollarsandcausinganappreciationoftheexchangerate.

Figure6-10

Fiscalexpansionsabroad,asdiscussedearlier,increasetheworldinterestrateandsoreduceinvestmentathome.Thisincreasesthesupplyofdollars,leadingtoadepreciationoftheexchangerate.Conversely,anexogenousincreaseindomesticinvestmentdemand(perhapsduetodomesticpoliciestostimulateinvestment)reducesnetcapitaloutflow,reducesthesupplyofdollars,andappreciatestheexchangerate.

TheEffectsofTradePolicies

Figure6-11

Thereisoftendiscussioninthenewsoftradepolicies—thatis,policiesdirectlytargetedatthetradebalance.Theseprincipallytaketheformoftariffs(taxesonimports)orquotas(restrictionsonthequantityofimports).Perhapssurprisingly,protectionistpoliciesofthissortarenotsuccessfulbecausetheysimplycauseappreciationoftheexchangeratewithoutaffectingthetradebalance.Onewaytoseethisistorememberthatthetradebalanceisequaltothedifferencebetweensavingandinvestment;sinceprotectionistpoliciesaffectneithersavingnorinvestment,theycannotaffectthelevelofnetexports.

Figure6-12

Protectionistpoliciesincreasethedemandfornetexports.Thisincreasesthedemandfordollars,causinganappreciationoftheexchangerate.Inthenewequilibrium,bothexportsandimportsarelower,butnetexportsareunchanged.

TheDeterminantsoftheNominalExchangeRate

Afterconsideringthedeterminantsoftherealexchangerate,ournextstepistothinkaboutthenominalexchangerate.Weknowthat

ε=eP/P*.

Bynowwearefamiliarenoughwithgrowthratestomovestraightfromthisequationto

∆ε/ε=∆e/e+π–π*,

or

∆e/e=∆ε/ε+(π*–π).

Thekeyconclusionisthatthenominalexchangeratewillchangenotonlybecauseofchangesintherealexchangeratebutalsobecauseofchangesintherealpurchasingpowerofcurrencies.Ifwehavehighinflationrelativetoothercountries,thattendstomakethenominalexchangeratedepreciate.

CaseStudy:InflationandNominalExchangeRates

Therelationshipbetweeninflationandnominalexchangeratesisevidentinthedata.Countrieswithveryhighratesofinflationexperiencemassivedepreciationoftheirexchangerate.Therelationshipisalsovisibleforcountriesexperiencingmoremoderateinflationrates.

TheSpecialCaseofPurchasing-PowerParity

Figure6-13

Supplement6-5,“TheExchangeRateandtheInflationRate”

Fromtheequation

∆e/e=∆ε/ε+(π*–π),

wecanseethatiftherealexchangerateneverchanged,thenmovementsinthenominalexchangeratewouldbeexplainedsolelybydifferencesininflationrates.Oneparticularandsi