HE191

Principles of Economics
Lecture 11

Chapters 31 and 32
Principles of Economics, Fourth Edition
N. Gregory Mankiw
 In this lecture, look for the answers to
these questions:
„ How are international flows of goods and assets related?
„ What’s the difference between the real and nominal
exchange rate?
„ What is “purchasing-power parity,” and how does it explain
nominal exchange rates?
„ In an open economy, what determines the real interest
rate? The real exchange rate?
„ How are the markets for loanable funds and foreign-
currency exchange connected?
„ How do government budget deficits affect the exchange
rate and trade balance?
„ How do other policies or events affect the
interest rate, exchange rate, and trade balance?
Closed vs. Open Economies
„ A closed economy does not interact with other
economies in the world.
„ An open economy interacts freely with other
economies around the world.

The Flow of Goods & Services

„ Exports:
domestically-produced g&s sold abroad
„ Imports:
foreign-produced g&s sold domestically
„ Net exports (NX)
= value of exports – value of imports
„ Another name for NX: the trade balance.
Variables that Influence Net Exports

„ consumers’ preferences for foreign and

domestic goods
„ prices of goods at home and abroad
„ incomes of consumers at home and abroad
„ the exchange rates at which foreign currency
trades for domestic currency
„ transportation costs
„ government policies
Trade Surpluses & Deficits

NX measures the imbalance in a country’s trade

in goods and services.
„Trade deficit:
an excess of imports over exports
„Trade surplus:
an excess of exports over imports
„Balanced trade:
when exports = imports
The Flow of Capital
„ Net capital outflow (NCO):
domestic residents’ purchases of foreign assets
minus
foreigners’ purchases of domestic assets
„ NCO is also called net foreign investment.
The flow of capital abroad takes two forms:
ƒ Foreign direct investment:
Domestic residents actively manage the foreign
investment, e.g., McDonalds opens a fast-food outlet
in Moscow.
ƒ Foreign portfolio investment:
Domestic residents purchase foreign stocks or bonds,
supplying “loanable funds” to a foreign firm.
The Flow of Capital
NCO measures the imbalance in a country’s trade in assets:
„ When NCO > 0, “capital outflow”
Domestic purchases of foreign assets exceed foreign
purchases of domestic assets.
„ When NCO < 0, “capital inflow”
Foreign purchases of domestic assets exceed domestic
purchases of foreign assets.
Variables that Influence NCO
„real interest rates paid on foreign assets and domestic
assets
„perceived risks of holding foreign assets
„govt policies affecting foreign ownership of domestic assets
The Equality of NX and NCO
„ An accounting identity: NCO = NX
„ arises because every transaction that affects NX also
affects NCO by the same amount (and vice versa)
„ When a foreigner purchases a good from the U.S.,
„ U.S. exports and NX increase
„ the foreigner pays with currency or assets, so the U.S.
acquires some foreign assets, causing NCO to rise.
„ When a U.S. citizen buys foreign goods,
„ U.S. imports rise, NX falls
„ the U.S. buyer pays with U.S. dollars or assets, so the
other country acquires U.S. assets, causing U.S. NCO
to fall.
Saving, Investment, and International
Flows of Goods & Assets
Y = C + I + G + NX accounting identity
Y – C – G = I + NX rearranging terms
S = I + NX since S = Y – C – G
S = I + NCO since NX = NCO
„ When S > I, the excess loanable funds flow
abroad in the form of positive net capital
outflow.
„ When S < I, foreigners are financing some of
the country’s investment, and NCO < 0.
Case Study: The U.S. Trade Deficit
„ In 2004, the U.S. had a record trade deficit.
„ Recall, NX = S – I = NCO.
A trade deficit means I > S,
so the nation borrows the difference
from foreigners.
„ In 2004, foreign purchases of U.S. assets
exceeded U.S. purchases of foreign assets by
$585 million.
„ Such deficits have been the norm since
1980…
Case Study: The U.S. Trade Deficit
Why U.S. saving has been less than investment:
„In the 1980s and early 2000s,
huge budget deficits and low private saving
depressed national saving.
„In the 1990s,
national saving increased as the economy
grew, but domestic investment increased even
faster due to the information technology boom.
Case Study: The U.S. Trade Deficit
„ Is the U.S. trade deficit a problem?
„ The extra capital stock from the ’90s investment
boom may well yield large returns
„ The fall in saving of the ’80s and ’00s,
while not desirable, at least did not depress
domestic investment, as firms could borrow from
abroad
„ A country, like a person, can go into debt
for good reasons or bad ones.
A trade deficit is not necessarily a problem,
but might be a symptom of a problem.
Case Study: The U.S. Trade Deficit
as of 12-31-2004
People abroad owned $12.5 trillion in U.S. assets.
U.S. residents owned $10 trillion in foreign assets.
U.S.’ net indebtedness to other countries = $2.5
trillion.
Higher than every other country’s net indebtedness.
So, U.S. is “the world’s biggest debtor nation.”
„ So far, the U.S. earns higher interest rates on foreign
assets than it pays on its debts to foreigners.
„ But if U.S. debt continues to grow, foreigners may
demand higher interest rates, and servicing the debt
would become a drain on U.S. income.
The Nominal Exchange Rate
„ Nominal exchange rate: the rate at which
one country’s currency trades for another
„ We express all exchange rates as foreign
currency per unit of domestic currency.
„ Some exchange rates as of 19 Oct 2007,
all per US$
Canadian dollar: 0.96
Euro: 0.70
Japanese yen: 115.15
Mexican peso: 10.79
Appreciation and Depreciation

„ Appreciation (or “strengthening”):

an increase in the value of a currency
as measured by the amount of foreign currency
it can buy
„ Depreciation (or “weakening”):
a decrease in the value of a currency
as measured by the amount of foreign currency
it can buy
„ Examples: During 2005, the U.S. dollar…
„appreciated 15% against the euro
„depreciated 5% against the Mexican peso
The Real Exchange Rate

„ Real exchange rate: the rate at which the

g&s of one country trade for the g&s of
another
exP
„ Real exchange rate =
P*
where
P = domestic price
P* = foreign price (in foreign currency)
e = nominal exchange rate, i.e., foreign
currency per unit of domestic currency
Example With One Good
„ A Big Mac costs $2.50 in U.S., 400 yen in Japan
„ e = 120 yen per $
„ e x P = price in yen of a U.S. Big Mac
= (120 yen per $) x ($2.50 per Big Mac)
= 300 yen per U.S. Big Mac
„ Compute the real exchange rate:

exP 300 yen per U.S. Big Mac

=
P* 400 yen per Japanese Big Mac
= 0.75 Japanese Big Macs per US Big Mac
Interpreting the Real Exchange Rate

“The real exchange rate =

0.75 Japanese Big Macs per U.S. Big Mac”
„ This does not mean a Japanese citizen
literally exchanges Japanese burgers for
American ones.
„ Correct interpretation:
To buy a Big Mac in the U.S.,
a Japanese citizen must sacrifice
an amount that could purchase
0.75 Big Macs in Japan.
The Real Exchange Rate With Many Goods

P = U.S. price level, e.g., Consumer Price Index,

which measures the price of a basket of goods
P* = foreign price level
Real exchange rate
= (e x P)/P*
= price of a domestic basket of goods relative to
price of a foreign basket of goods
„ An appreciation of the U.S. real exchange rate
means U.S. goods are becoming more expensive
relative to foreign goods.
The Law of One Price
„ Law of one price: the notion that a good
should sell for the same price in all markets
„Suppose coffee sells for $4/pound in Seattle
and $5/pound in Boston,
and can be costlessly transported.
„There is an opportunity for arbitrage,
making a quick profit by buying coffee in
Seattle and selling it in Boston.
„Such arbitrage drives up the price in Seattle
and drives down the price in Boston, until the
two prices are equal.
Purchasing-Power Parity (PPP)

„ Purchasing-power parity:
a theory of exchange rates whereby a unit of
any currency should be able to buy the same
quantity of goods in all countries
„ based on the law of one price
„ implies that nominal exchange rates adjust
to equalize the price of a basket of goods
across countries
PPP and Its Implications
„ PPP implies that the nominal
P*
exchange rate between two countries e =
P
should equal the ratio of price levels.
„ If the two countries have different inflation rates,
then e will change over time:
„ If inflation is higher in Mexico than in the U.S.,
then P* rises faster than P, so e rises –
the dollar appreciates against the peso.
„ If inflation is higher in the U.S. than in Japan,
then P rises faster than P*, so e falls –
the dollar depreciates against the yen.
Limitations of PPP Theory
Two reasons why exchange rates do not always adjust to
equalize prices across countries:
„ Many goods cannot easily be traded
„ Examples: haircuts, going to the movies
„ Price differences on such goods cannot be arbitraged
away
„ Foreign, domestic goods not perfect substitutes
„ E.g., some U.S. consumers prefer Toyotas over
Chevys, or vice versa
„ Price differences reflect taste differences
„ Nonetheless, PPP works well in many cases, especially as
an explanation of long-run trends.
„ For example, PPP implies:
the greater a country’s inflation rate, the faster its
currency should depreciate (relative to a low-inflation
country like the US).
Open Macroeconomics: The Market for
Loanable Funds
„ Recall the identity:

S = I + NCO
Saving Net capital
Domestic
outflow
investment
„ Supply of loanable funds = saving.
„ A dollar of saving can be used to finance
„ the purchase of domestic capital
„ the purchase of a foreign asset
„ So, demand for loanable funds = I + NCO
How NCO Depends on the Real Interest Rate
The real interest rate, r,
is the real return on Net capital outflow
r
domestic assets.
A fall in r makes domestic
assets less attractive
relative to foreign assets. r1
„ People in the U.S. r2
purchase more foreign
assets.
„ People abroad NCO
purchase fewer U.S. NCO
assets. NCO1 NCO2
„ NCO rises.
The Loanable Funds Market Diagram

rr adjusts
adjusts to
to balance
balance supply
supply
Loanable funds
r and
and demand
demand in in the
the LF
LF market.
market.
S = saving
Both
Both II and
and NCO
NCO
depend
depend negatively
negatively onon r,
r,
r1 so
so the
the DD curve
curve is
is
downward-sloping.
downward-sloping.
D = I + NCO

LF
The Market for Foreign-Currency Exchange
„ Recall another identity:
NCO = NX
Net capital
outflow Net exports

„ In the market for foreign-currency exchange,

„ NX is the demand for dollars, because
foreigners need dollars to buy U.S. net exports.
„ NCO is the supply of dollars, because
U.S. residents sell dollars to obtain the foreign
currency they need to buy foreign assets.
The Market for Foreign-Currency Exchange

„ Recall:
The U.S. real exchange rate (E) measures
the quantity of foreign goods & services
that trade for one unit of U.S. goods & services.
„ E is the real value of a dollar in the market for
foreign-currency exchange.
„ E adjusts to balance supply and demand for
dollars in the market for foreign- currency
exchange.
The Market for Foreign-Currency Exchange

An increase in E makes
U.S. goods more E S = NCO
expensive to foreigners,
reduces foreign demand
for U.S. goods – and
E1
U.S. dollars.
An increase in E
has no effect on saving D = NX
or investment, so it does
not affect NCO or the Dollars
supply of dollars.
FYI: Disentangling Supply and Demand
When a U.S. resident buys imported goods,
does the transaction affect supply or demand
in the foreign exchange market? Two views:
1. The supply of dollars increases.
The person needs to sell her dollars to obtain the
foreign currency she needs to buy the imports.
2. The demand for dollars decreases.
The increase in imports reduces NX,
which we think of as the demand for dollars.
(So, NX is really the net demand for dollars.)
Both views are equivalent. For our purposes,
it’s more convenient to use the second.
FYI: Disentangling Supply and Demand
When a foreigner buys a U.S. asset,
does the transaction affect supply or demand
in the foreign exchange market? Two views:
1. The demand for dollars increases.
The foreigner needs dollars in order to purchase the
U.S. asset.
2. The supply of dollars falls.
The transaction reduces NCO, which we think of
as the supply of dollars.
(So, NCO is really the net supply of dollars.)
Again, both views are equivalent. We will use the
second.
 Net
Net exports
exports and
and the
the budget
budget deficit
deficit
The “Twin Deficits” often
often move
move inin opposite
opposite directions.
directions.
5%
4% U.S. federal
3% budget deficit
Percent of GDP

2%
1%
0%
-1%
-2%
-3% U.S. net exports
-4%
-5%

1995-2000
1991-95
1986-90

2001-05
1981-85
1961-65

1966-70

1971-75

1976-80
The Effects of a Budget Deficit: Summary

• national saving falls

• the real interest rate rises
• domestic investment and net capital outflow
both fall
• the real exchange rate appreciates
• net exports fall (or, the trade deficit increases)
 The Connection Betweenr
Interest Rates r2

and Exchange Rates r1

NCO
Anything that increases r NCO
will reduce NCO NCO2 NCO1

and the supply of dollars in E

S2 S1 = NCO1
the foreign exchange
market. E2
E1
Result:
The real exchange rate D = NX
appreciates. dollars
NCO2 NCO1
Budget Deficit vs. Investment Incentives

„ A tax incentive for investment has similar effects

as a budget deficit:
„ r rises, NCO falls
„ E rises, NX falls
„ But one important difference:
„ Investment tax incentive increases investment,
which increases productivity growth and living
standards in the long run.
„ Budget deficit reduces investment,
which reduces productivity growth and living
standards.
Trade Policy

„ Trade policy:
a govt policy that directly influences the quantity of
g&s that a country imports or exports
„ Examples:
„ Tariff – a tax on imports
„ Import quota – a limit on the quantity of
imports
„ “Voluntary export restrictions” – the govt
pressures another country to restrict its exports;
essentially the same as an import quota
Trade Policy

„ Common reasons for policies to restrict

imports:
„ to save jobs in a domestic industry that has
difficulty competing with imports
„ to reduce the trade deficit
„ Do such trade policies accomplish these goals?
„ Let’s use our model to analyze the effects of
an import quota on cars from Japan,
designed to save jobs in the U.S. auto industry.
Analysis of a Quota on Cars from Japan
An import quota does not affect saving or investment,
so it does not affect NCO. (Recall: NCO = S – I.)
Loanable funds Net capital outflow
r r
S

r1 r1

D NCO
LF NCO
Analysis of a Quota on Cars from Japan

Since NCO unchanged, Market for foreign-

S curve does not shift. currency exchange

The D curve shifts: E S = NCO

At each E,
imports of cars fall, E2
so net exports rise,
D shifts to the right. E1
At E1, there is excess D2
demand in the foreign
D1
exchange market.
E rises to restore eq’m. Dollars
Analysis of a Quota on Cars from Japan, cont.

What happens to NX? Nothing!

„ If E could remain at E1, NX would rise, and the
quantity of dollars demanded would rise.
„ But the import quota does not affect NCO,
so the quantity of dollars supplied is fixed.
„ Since NX must equal NCO, E must rise enough
to keep NX at its original level.
„ Hence, the policy of restricting auto imports
from Japan does not reduce the trade deficit.
 Analysis of a Quota on Cars from Japan, cont.
Does the policy save jobs?
The quota reduces imports of Japanese autos.
„ U.S. consumers buy more U.S. autos.
„ U.S. automakers hire more workers to produce these
extra cars.
„ So the policy saves jobs in the U.S. auto industry.
But E rises, reducing foreign demand for U.S. exports.
„ Export industries contract, exporting firms lay off
workers.
The import quota saves jobs in the auto industry
only by destroying jobs in U.S. export industries!!
Political Instability and Capital Flight

„ 1994: Political instability in Mexico made world

financial markets nervous.
„ People worried about the safety of Mexican
assets they owned.
„ People sold many of these assets, pulled their
capital out of Mexico.
„ Capital flight: a large and sudden reduction
in the demand for assets located in a country
„ We analyze this using our model, but from the
prospective of Mexico, not the U.S.
 Capital Flight from Mexico
Loanable funds Net capital outflow
r r
S1

r2 r2
r1 r1
D2 NCO2
D1 NCO1
LF NCO
As foreign investors sell their assets and pull out their capital,
NCO increases at each value of r. Demand for LF = I + NCO.
The increase in NCO increases demand for LF.
The equilibrium values of r and NCO both increase.
Capital Flight from Mexico

The increase in NCO Market for foreign-

causes an increase in currency exchange
the supply of pesos in
E S1 = NCO1
the foreign exchange
market. S2 = NCO2

The real exchange rate

value of the peso falls. E1

E2
D1

Pesos
Real-World Examples of Capital Flight

„ Mexico, 1994
„ Southeast Asia, 1997
„ Russia, 1998
„ Argentina, 2002

In
In each
each ofof these
these cases,
cases,
the
the country
country’s’s interest
interest rates
rates rose
rose and
and
its
its exchange
exchange rate rate depreciated,
depreciated,
as
as our
our model
model predicts.
predicts.