Worth: Mankiw Economics 5e n Economy 119 International Flows of Goods and Capital An Example The equality of net exports and net capital outflow The opposite situation occurs in Japan. When is an identity: it must hold by the way the numbers the Japanese consumer buys a copy of the win- are added up. But it is easy to miss the intuition i dows operating system, Japan's purchases of behind this important relationship. The best wayi goods and services(C+I+G)rise, but there is no to understand it is to consider an example change in what Japan has produced(Y). The Imagine that Bill Gates sells a copy of the transaction reduces Japan's saving(S=Y-C-G Windows operating system to a Japanese con-i for a given level of investment(D). While the U.S umer for 5,000 yen. Because Mr Gates is a U.S. experiences a net capital outflow, Japan experi resident, the sale represents an export of the i ences a net capital inflow United States. Other things equal, U.Snet ex- Now let's change the example. Suppose that ports rise. What else happens to make the iden-i instead of investing his 5,000 yen in a Japanese tity hold? It depends on what Mr. Gates does asset, Mr Gates uses it to buy something made with the 5,000 yen. in Japan, such as a Sony Walkman. In this case, Suppose Mr. Gates decides to stuff the 5,000 imports into the United State rise. Together, the yen in his mattress. In this case, Mr Gates has al- Windows export and the Walkman import repre- located some of his saving to an investment in i sent balanced trade between Japan and the the Japanese economy (in the form of the Japan-! United States.Be ates. Because exports and imports rise ese currency)rather than to an investment in the i equally, net exports and net capital outflow are U.S. economy. Thus, U.S. saving exceeds U.S. in-i both unchanged estment. The rise in U.S. net exports is matched A final possibility is that Mr. Ga ates exchanges by a rise in the U.S. net capital outflow his 5,000 yen for U.S. dollars at a local bank. But If Mr Gates wants to invest in Japan, however, this doesn't change the situation: the bank now he is unlikely to make currency his asset of i has to do something with the 5,000 yen. It can choice. He might use the 5,000 yen to buy somei buy Japanese assets(a U.S. net capital outflow); stock in, say, the Sony Corporation, or he might it can buy a Japanese good (a U.S. import); or it buy a bond issued by the Japanese government.i can sell the yen to another American who wants In either case, some of U.S. saving is flowing i to make such a transaction. If you follow the abroad. Once again, the U.S. net capital outflow money, you can see that, in the end, U.S. net ex- exactly balances U.S. net exports ports must equal U.S. net capital outflow goods and services than we export. That is, we are running a trade deficit. Table 5-1 summarizes these lessons Note that the international How of capital can take many forms. It is easiest to assume-as we have done so far--that when we run a trade deficit, foreigners make loans to us. This happens, for example, when the Japanese buy the debt is- sued by U.S. corporations or by the U.S. government. But the flow of capital car also take the form of foreigners buying domestic assets, such as when a citizen of Germany buys stock from an American on the New York Stock Exchange Whether foreigners are buying domestically issued debt or domestically owned cases, foreigners end up owning some of the domestic capital stoc pital. In both assets, they are obtaining a claim to the future returns to domestic cap User JOENA: Job EFF01460: 6264_ch05: Pg 119: 26240#/eps at 100s wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 119:26240#/eps at 100% *26240* Wed, Feb 13, 2002 9:26 AM goods and services than we export.That is, we are running a trade deficit.Table 5-1 summarizes these lessons. Note that the international flow of capital can take many forms. It is easiest to assume—as we have done so far—that when we run a trade deficit, foreigners make loans to us.This happens, for example, when the Japanese buy the debt issued by U.S. corporations or by the U.S. government. But the flow of capital can also take the form of foreigners buying domestic assets, such as when a citizen of Germany buys stock from an American on the New York Stock Exchange. Whether foreigners are buying domestically issued debt or domestically owned assets, they are obtaining a claim to the future returns to domestic capital. In both cases, foreigners end up owning some of the domestic capital stock. CHAPTER 5 The Open Economy | 119 FYI The equality of net exports and net capital outflow is an identity: it must hold by the way the numbers are added up. But it is easy to miss the intuition behind this important relationship. The best way to understand it is to consider an example. Imagine that Bill Gates sells a copy of the Windows operating system to a Japanese consumer for 5,000 yen. Because Mr. Gates is a U.S. resident, the sale represents an export of the United States. Other things equal, U.S. net exports rise. What else happens to make the identity hold? It depends on what Mr. Gates does with the 5,000 yen. Suppose Mr. Gates decides to stuff the 5,000 yen in his mattress. In this case, Mr. Gates has allocated some of his saving to an investment in the Japanese economy (in the form of the Japanese currency) rather than to an investment in the U.S. economy. Thus, U.S. saving exceeds U.S. investment. The rise in U.S. net exports is matched by a rise in the U.S. net capital outflow. If Mr. Gates wants to invest in Japan, however, he is unlikely to make currency his asset of choice. He might use the 5,000 yen to buy some stock in, say, the Sony Corporation, or he might buy a bond issued by the Japanese government. In either case, some of U.S. saving is flowing abroad. Once again, the U.S. net capital outflow exactly balances U.S. net exports. International Flows of Goods and Capital: An Example The opposite situation occurs in Japan. When the Japanese consumer buys a copy of the Windows operating system, Japan’s purchases of goods and services (C + I + G) rise, but there is no change in what Japan has produced (Y). The transaction reduces Japan’s saving (S = Y − C − G) for a given level of investment (I). While the U.S. experiences a net capital outflow, Japan experiences a net capital inflow. Now let’s change the example. Suppose that instead of investing his 5,000 yen in a Japanese asset, Mr. Gates uses it to buy something made in Japan, such as a Sony Walkman. In this case, imports into the United State rise. Together, the Windows export and the Walkman import represent balanced trade between Japan and the United States. Because exports and imports rise equally, net exports and net capital outflow are both unchanged. A final possibility is that Mr. Gates exchanges his 5,000 yen for U.S. dollars at a local bank. But this doesn’t change the situation: the bank now has to do something with the 5,000 yen. It can buy Japanese assets (a U.S. net capital outflow); it can buy a Japanese good (a U.S. import); or it can sell the yen to another American who wants to make such a transaction. If you follow the money, you can see that, in the end, U.S. net exports must equal U.S. net capital outflow
Worth: Mankiw Economics 5e 120 PART 11 Classical Theory: The Economy in the Long Run 5-2 Saving and Investment in a Small Open Economy So far in our discussion of the international flows of goods and capital, we have merely rearranged accounting identities. That is, we have defined some of the variables that measure transactions in an open economy, and we have shown the nks among these variables that follow from their definitions. Our next step is to develop a model that explains the behavior of these variables. We can then use he model to answer questions such as how the trade balance responds to Capital Mobility and the World Interest Rate In a moment we present a model of the international flows of capital and goods Because the trade balance equals the net capital outflow, which in turn equals saving minus investment, our model focuses on saving and investment. To de velop this model, we use some elements that should be familiar from Chapter 3, but in contrast to the Chapter 3 model, we do not assume that the real interest rate equilibrates saving and investment. Instead, we allow the economy to run a trade deficit and borrow from other countries, or to run a trade surplus and lend to other countries If the real interest rate does not adjust to equilibrate saving and investment this model, what does determine the real interest rate? We answer this question here by considering the simple case of a small open economy with perfect capital mobility. By"small"we mean that this economy is a small part of the world market and thus, by itself, can have only a negligible effect on the world interest rate. By "perfect capital mobility we mean that residents of the country have full access to world financial markets. In particular, the government does not impede international borrowing or lending Because of this assumption of perfect capital mobility, the interest rate in our small open economy, r, must equal the world interest rate r, the real interest rate prevailing in world financial markets idents of the small open economy need never borrow at any interest rate above r, because they can always get a loan at r*from abroad. Similarly, residents of this economy need never lend at any interest rate below r because they can always earn r* by lending abroad. Thus, the world interest rate determines the in- terest rate in our small open economy Let us discuss for a moment what determines the world real interest rate. In a closed economy, the equilibrium of domestic saving and domestic investment determines the interest rate. Barring interplanetary trade, the world economy is a losed economy. Therefore, the equilibrium of world saving and world invest ment determines the world interest rate. Our small open economy has a negligi ble effect on the world real interest rate because, being a small part of the world User JOENA: Job EFF01460: 6264_ch05: Pg 120: 26241#/eps at 100s wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 120:26241#/eps at 100% *26241* Wed, Feb 13, 2002 9:26 AM 5-2 Saving and Investment in a Small Open Economy So far in our discussion of the international flows of goods and capital, we have merely rearranged accounting identities. That is, we have defined some of the variables that measure transactions in an open economy, and we have shown the links among these variables that follow from their definitions. Our next step is to develop a model that explains the behavior of these variables.We can then use the model to answer questions such as how the trade balance responds to changes in policy. Capital Mobility and the World Interest Rate In a moment we present a model of the international flows of capital and goods. Because the trade balance equals the net capital outflow, which in turn equals saving minus investment, our model focuses on saving and investment. To develop this model, we use some elements that should be familiar from Chapter 3, but in contrast to the Chapter 3 model, we do not assume that the real interest rate equilibrates saving and investment. Instead, we allow the economy to run a trade deficit and borrow from other countries, or to run a trade surplus and lend to other countries. If the real interest rate does not adjust to equilibrate saving and investment in this model, what does determine the real interest rate? We answer this question here by considering the simple case of a small open economy with perfect capital mobility. By “small’’ we mean that this economy is a small part of the world market and thus, by itself, can have only a negligible effect on the world interest rate. By “perfect capital mobility’’ we mean that residents of the country have full access to world financial markets. In particular, the government does not impede international borrowing or lending. Because of this assumption of perfect capital mobility, the interest rate in our small open economy, r, must equal the world interest rate r*, the real interest rate prevailing in world financial markets: r = r*. Residents of the small open economy need never borrow at any interest rate above r*, because they can always get a loan at r* from abroad. Similarly, residents of this economy need never lend at any interest rate below r* because they can always earn r* by lending abroad.Thus, the world interest rate determines the interest rate in our small open economy. Let us discuss for a moment what determines the world real interest rate. In a closed economy, the equilibrium of domestic saving and domestic investment determines the interest rate. Barring interplanetary trade, the world economy is a closed economy. Therefore, the equilibrium of world saving and world investment determines the world interest rate. Our small open economy has a negligible effect on the world real interest rate because, being a small part of the world, 120 | PART II Classical Theory: The Economy in the Long Run
Worth: Mankiw Economics 5e CHAPTER 5 The Open Economy 121 has a negligible effect on world saving and world investment. Hence, our small open economy takes the world interest rate as exogenously given The Model To build the model of the small open economy, we take three assumptions from The economys output Y is fixed by the factors of production and the pro- duction function We write this as Y=Y=FK. L Consumption C is positively related to disposable income Y-T. We write the consumption function as C=C(Y-T Investment I is negatively related to the real interest rate r. We write the investment function as These are the three key parts of our model. If you do not understand these rela tionships, review Chapter 3 before continuing. We can now return to the accounting identity and write it as XX=S-I Substituting our three assumptions from Chapter 3 and the condition that the interest rate equals the world interest rate, we obtain NX=Y-C(Y-T)-G-I(r) I(r*) This equation shows what determines saving S and investment I-and thus the trade balance NX. Remember that saving depends on fiscal policy: lower govern- ment purchases G or higher taxes T raise national saving Investment depends on the world real interest rate r*: high interest rates make some investment projects unprofitable. Therefore, the trade balance depends on these variables as well. In Chapter 3 we graphed saving and investment as in Figure 5-2 In the closed economy studied in that chapter, the real interest rate adjusts to equilibrate saving and investment--that is the real interest rate is found where the saving and in- vestment curves cross. In the small open economy, however, the real interest rate equals the world real interest rate. The trade balance is determined by the difference be tween saving and investment at the world interest rate. 6 At this point, you might wonder about the mechanism that causes the trade ance to equal the net capital outflow. The determinants of the capital flows are User JoNA:JobE01460:6264ch05:9121:262424#/epat100|lⅢ wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 121:26242#/eps at 100% *26242* Wed, Feb 13, 2002 9:26 AM it has a negligible effect on world saving and world investment. Hence, our small open economy takes the world interest rate as exogenously given. The Model To build the model of the small open economy, we take three assumptions from Chapter 3: ➤ The economy’s output Y is fixed by the factors of production and the production function.We write this as Y = Y _ = F(K _ , L _ ). ➤ Consumption C is positively related to disposable income Y − T. We write the consumption function as C = C(Y − T). ➤ Investment I is negatively related to the real interest rate r. We write the investment function as I = I(r). These are the three key parts of our model. If you do not understand these relationships, review Chapter 3 before continuing. We can now return to the accounting identity and write it as NX = (Y − C − G) − I NX = S − I. Substituting our three assumptions from Chapter 3 and the condition that the interest rate equals the world interest rate, we obtain NX = [Y _ − C(Y _ − T) − G] − I(r*) = S _ − I(r*). This equation shows what determines saving S and investment I—and thus the trade balance NX. Remember that saving depends on fiscal policy: lower government purchases G or higher taxes T raise national saving. Investment depends on the world real interest rate r*: high interest rates make some investment projects unprofitable.Therefore, the trade balance depends on these variables as well. In Chapter 3 we graphed saving and investment as in Figure 5-2. In the closed economy studied in that chapter, the real interest rate adjusts to equilibrate saving and investment—that is, the real interest rate is found where the saving and investment curves cross. In the small open economy, however, the real interest rate equals the world real interest rate.The trade balance is determined by the difference between saving and investment at the world interest rate. At this point, you might wonder about the mechanism that causes the trade balance to equal the net capital outflow. The determinants of the capital flows are CHAPTER 5 The Open Economy | 121
Worth: Mankiw Economics 5e 22 PART I1 Classical Theory: The Economy in the Long Run figure 5-2 Real interest S Saving and Investment in a rate, r Trade surplus Small Open Economy In a closed economy, the real interest rate adjusts to equilibrate saving and investment In a small open economy, the interest rate is de- termined in world financial mar est kets. The difference between rate saving and investment deter mines the trade balance. Here nterest there is a trade surplus, because rate if the at the world interest rate, saving I(r exceeds investment were closed easy to understand. When saving falls short of investment, investors borrow from exceeds invest le what causes those who import and export to behave in a way that ensures that the international flow of goods exactly balances this international flow of capital For now we leave this question unanswered, but we return to it in Section 5-3 when we discuss the determination of exchange rates How Policies influence the trade balance Suppose that the economy begins in a position of balanced trade. That is, at the world interest rate, investment Equals saving S, and net exports NX equal zero. Let's use our model to predict the effects of government policies at home and abroad. Fiscal Policy at Home Consider first what happens to the small open econ- omy if the government expands domestic spending by increasing government purchases. The increase in G reduces national saving, because S=Y-C-G With an unchanged world real interest rate, investment remains the same. There fore, saving falls below investment, and some investment must now be financed by borrowing from abroad. Because NX=S-L, the fall in S implies a fall in NX. The economy now runs a trade deficit. The same logic applies to a decrease in taxes. a tax cut lowers T, raises able income Y-T, stimulates consumption, and reduces national saving chough some of the tax cut finds its way into private saving, public saving falls by he full amount of the tax cut; in total, saving falls. Because NX=S-I, the duction in national saving in turn lowers NX. Figure 5-3 illustrates these effects. A fiscal-policy change that increases private consumption C or public consumption G reduces national saving(Y-C-G) and, therefore, shifts the vertical line that represents saving from S, to S2. Because NX is the distance between the saving schedule and the investment schedule at the world interest rate, this shift reduces NX. Hence, starting from balanced trade, a change in fiscal policy that reduces national saving leads to a trade deficit User JoENA: Job EFFo1460: 6264_ ch05: Pg 122: 26243#/eps at 100sl I wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 122:26243#/eps at 100% *26243* Wed, Feb 13, 2002 9:26 AM easy to understand.When saving falls short of investment, investors borrow from abroad; when saving exceeds investment, the excess is lent to other countries. But what causes those who import and export to behave in a way that ensures that the international flow of goods exactly balances this international flow of capital? For now we leave this question unanswered, but we return to it in Section 5-3 when we discuss the determination of exchange rates. How Policies Influence the Trade Balance Suppose that the economy begins in a position of balanced trade. That is, at the world interest rate,investment I equals saving S,and net exports NX equal zero.Let’s use our model to predict the effects of government policies at home and abroad. Fiscal Policy at Home Consider first what happens to the small open economy if the government expands domestic spending by increasing government purchases.The increase in G reduces national saving, because S = Y − C − G. With an unchanged world real interest rate, investment remains the same.Therefore, saving falls below investment, and some investment must now be financed by borrowing from abroad. Because NX = S − I, the fall in S implies a fall in NX. The economy now runs a trade deficit. The same logic applies to a decrease in taxes.A tax cut lowers T, raises disposable income Y − T, stimulates consumption, and reduces national saving. (Even though some of the tax cut finds its way into private saving, public saving falls by the full amount of the tax cut; in total, saving falls.) Because NX = S − I, the reduction in national saving in turn lowers NX. Figure 5-3 illustrates these effects. A fiscal-policy change that increases private consumption C or public consumption G reduces national saving (Y − C − G) and, therefore, shifts the vertical line that represents saving from S1 to S2. Because NX is the distance between the saving schedule and the investment schedule at the world interest rate, this shift reduces NX. Hence, starting from balanced trade, a change in fiscal policy that reduces national saving leads to a trade deficit. 122 | PART II Classical Theory: The Economy in the Long Run figure 5-2 Real interest rate, r* r* NX S Investment, Saving, I, S I(r) World interest rate Trade surplus Interest rate if the economy were closed Saving and Investment in a Small Open Economy In a closed economy, the real interest rate adjusts to equilibrate saving and investment. In a small open economy, the interest rate is determined in world financial markets. The difference between saving and investment determines the trade balance. Here there is a trade surplus, because at the world interest rate, saving exceeds investment
Worth: Mankiw Economics 5e Real interest A Fiscal Expansion at Home in a rate, r 2 but when a Small Open Economy An increase n government purchases or a re- reduces saving duction in taxes reduces nationa saving and thus shifts the saving 1. This economy schedule to the left, from St to S The result is a trade deficit balanced trade deficit results (r) 1. S Fiscal Policy Abroad Consider now what happens to a small open economy when foreign governments increase their government purchases. If these foreign countries are a small part of the world economy, then their fiscal change has a gligible impact on other countries. But if these foreign countries are a large art of the world economy, their increase in government purchases reduces world saving and causes the world interest rate to rise The increase in the world interest rate raises the cost of borrowing and, thus, reduces investment in our small open economy. Because there has been no hange in domestic saving, saving S now exceeds investment I, and some of our saving begins to flow abroad. Since NX=S-L the reduction in I must also in- crease NX. Hence, reduced saving abroad leads to a trade surplus at home. cro igure 5-4 illustrates how a small open economy starting from balanced trade onds to a foreign fiscal expansion. Because the policy change is occurring figure 5-4 Real interest A Fiscal Expansion Abroad in a Small Open Economy A fiscal ex- pansion in a foreign economy large enough to influence world a trade surplus saving and investment raises the world interest rate from ri to r2 The higher world interest rate 1. An reduces investment in open economy, causing a trade surplus. Interest rate nvestment, Saving, ,S User JoNA:JobE01460:6264ch05:9123:26248#/epat100|l川ⅢⅢ wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 123:26248#/eps at 100% *26248* Wed, Feb 13, 2002 9:26 AM Fiscal Policy Abroad Consider now what happens to a small open economy when foreign governments increase their government purchases. If these foreign countries are a small part of the world economy, then their fiscal change has a negligible impact on other countries. But if these foreign countries are a large part of the world economy, their increase in government purchases reduces world saving and causes the world interest rate to rise. The increase in the world interest rate raises the cost of borrowing and, thus, reduces investment in our small open economy. Because there has been no change in domestic saving, saving S now exceeds investment I, and some of our saving begins to flow abroad. Since NX = S − I, the reduction in I must also increase NX. Hence, reduced saving abroad leads to a trade surplus at home. Figure 5-4 illustrates how a small open economy starting from balanced trade responds to a foreign fiscal expansion. Because the policy change is occurring CHAPTER 5 The Open Economy | 123 figure 5-3 Real interest rate, r r* NX S1 Investment, Saving, I, S I(r) S2 2. . . . but when a fiscal expansion reduces saving . . . 1. This economy begins with balanced trade, . . . 3. . . . a trade deficit results. A Fiscal Expansion at Home in a Small Open Economy An increase in government purchases or a reduction in taxes reduces national saving and thus shifts the saving schedule to the left, from S1 to S2. The result is a trade deficit. figure 5-4 Real interest rate, r r*2 r*1 NX S Investment, Saving, I, S I(r) 1. An increase in the world interest rate . . . 2. . . . reduces investment and leads to a trade surplus. A Fiscal Expansion Abroad in a Small Open Economy A fiscal expansion in a foreign economy large enough to influence world saving and investment raises the world interest rate from r1 * to r2 *. The higher world interest rate reduces investment in this small open economy, causing a trade surplus