Source of text materials: Mankiw (2009) Macroeconomics, 7th Ed.
Source of data materials: World Bank Imports and exports as a percentage of output: ASEAN, 2010 0 50 100 150 200 250 Exports of goods and services (% of GDP) The International Flow of Capital and Goods The Role of Net Exports
In an open economy, some output is sold domestically and some is exported to be sold abroad. Then, the output Y is expressed in the identity:
Y = C + I + G + X
C = consumption of domestic goods & services I = investment in domestic goods & services G = gov purchases of domestic goods & services X = exports of domestic goods & services The International Flow of Capital and Goods Note that all domestic spending are equals domestic spending on domestic goods & services plus domestic spending on foreign goods & services. So:
C = C + C I = I + I G = G + G
Y = (C C) + (I I) + (G G) + X Y = C + I + G + X (C + I + G) Y = C + I + G + X IM Y = C + I + G + NX Substitute into : Y = C + I + G + X The International Flow of Capital and Goods Therefore, we can conclude that:
NX = Y (C + I + G)
If output exceeds domestic spending, we export the difference: net exports are positive (NX > 0). If output falls short of domestic spending, we import the difference: net exports are negative (NX < 0). Net Exports Output Domestic Spending The International Flow of Capital and Goods International Capital Flows & the Trade Balance
Recall from Chapter 3: financial markets and goods markets are closely related. Y = C + I + G + NX Y C G = I + NX S = I + NX S I = NX Net Capital Outflow = Trade Balance Saving & Investment in a Small Open Economy Capital Mobility & the World Interest Rate
Since the trade balance equals net capital outflow, our model focuses on saving and investment. Instead of using equilibrium interest rate, we rather use world interest rate (r*) because the economy may run a trade surplus or trade deficit.
r = r *
However, this is represents the case of small open economy with perfect capital mobility. Saving & Investment in a Small Open Economy Saving and investment in small open economy: r I, S 0 I(r ) S r* NX Saving & Investment in a Small Open Economy How Policies Influence the Trade Balance
Fiscal Expansion at Home an increase in government expenditure or a reduction in taxes reduces national saving, thus: trade deficit.
Fiscal Expansion Abroad a fiscal expansion at foreign big open economy is strong enough to raise the world interest rate, thus: trade surplus.
Shift in the Investment Schedule an outward shift in investment schedule increases the actual investment at r* and exceeds saving, thus: trade deficit. Exchange Rates Is the price of which residents of two countries trade with each other during the trade transaction. Exchange Rates Nominal & Real Exchange Rates
The Nominal Exchange Rates is the relative price of the currencies of two countries.
Appreciation is the rise in the exchange rate (strengthening of the currency) Depreciation is the fall in the exchange rate (weakening of the currency) Exchange Rate = Foreign Currency Local Currency Exchange Rates Trend in Rupiahs exchange rate: 0 0.0001 0.0002 0.0003 0.0004 0.0005 0.0006 0.0007 1987 1990 1993 1996 1999 2002 2005 2008 2011 Official Exchange Rate ($/Rp, period Exchange Rates Comparison in ASEANs currency exchange rate (2011): Country $/Local Local/$ Singapore 0.795054205 1.2578 Brunei Darussalam 0.794967525 1.2579 Malaysia 0.326797064 3.0600 Thailand 0.032795774 30.4917 Philippines 0.023087684 43.3131 Cambodia 0.000246396 4058.5000 Lao 0.000121083 8258.7701 Indonesia 0.000114019 8770.4333 Vietnam 0.000048757 20509.7500 Exchange Rates The Real Exchange Rates is the relative price of the goods of two countries (also known as terms of trade).
If the real exchange rate () is high, foreign goods are relatively cheap, and domestic goods are relatively expensive.
Real Exchange Rate = Nominal Exchange Rate x Domestic Price Foreign Price
= e P P* Exchange Rates The Real Exchange Rate & the Trade Balance
Since the real exchange rate express the price ratio of domestic goods to foreign goods, it affects the demand for these goods (which turns into Net Exports = NX).
Exchange Rates Relationship between real exchange rate and net export:
Net Exports 0 NX() Exchange Rates The Determinant of the Real Exchange Rate
1. The real exchange rate () is related to net exports (NX). It appears to has negative correlation. 2. The trade balance (the net exports) must equal to net capital outflow, which in turn equals to savings minus investment (S-I). Saving is fixed by the consumption function and fiscal policy; Investment is fixed by the investment function and world interest rate. Exchange Rates How Policies Influence the Real Exchange Rate
Fiscal Expansion at Home an increase in government expenditure or a reduction in taxes reduces national saving, thus: increasing , decreasing NX. Fiscal Expansion Abroad a fiscal expansion at foreign big open economy is strong enough to raise the world interest rate and reduce world saving, thus: decreasing , increasing NX. Shift in the Investment Schedule an outward shift in investment schedule increases the actual domestic investment, thus: increasing , decreasing NX. Exchange Rates How the real exchange rate is determined: Net Exports NX() S-I
* Exchange Rates The Effect of Trade Policies
Protectionist Trade Policies a ban on imported commodities or a regulate on particular import quota or impose a tariff on imported commodities would raise the demand for net exports, thus: increasing , unchanged NX (because the protectionist trade policy does alter neither saving nor investment). Exchange Rates The Determinants of the Nominal Exchange Rate
Recall the relationship of two exchange rates: = e P P* e =
+ P*
P e P* P e = P* P e =
+ ( * ) e Exchange Rates The Special Case of PPP
The Law of One Price states that the same good cannot sell for different prices in different places at the same time. Arbitrageurs are people who specialize in buying low in one market and selling high in another. This opportunistic thereby ensuring that prices are equalized in the two markets.
Purchasing Power Parity (PPP) is the international term for the Law of One Price. If international arbitrage is possible, then a currency must have the same purchasing power in every country. Exchange Rates PPP suggested that NX are highly sensitive to : Net Exports NX() S-I