Worth: Mankiw Economics 5e 124 PART 11 Classical Theory: The Economy in the Long Run abroad, the domestic saving and investment schedules remain the same. The only change is an increase in the world interest rate from ri to r2.The bala he difference between the saving and investment schedules; because saving ex ceeds investment at r2, there is a trade surplus. Hence, an increase in the world inter- Shifts in Investment Demand Consider what happens to our small open economy if its investment schedule shifts outward--that is, if the demand for in- vestment goods at every interest rate increases. This shift would occur if, for ex- ample, the government changed the tax laws to encourage investment by providing an investment tax credit. Figure 5-5 illustrates the impact of a shift in the investment schedule. At a given world interest rate, investment is now higher. Because saving is unchanged, some investment must now be financed by bor- rowing from abroad, which means the net capital outflow is negative. Put differ- ently, because NX= S-I, the increase in I implies a decrease in NX. Hence, an outward shift in the investment schedule causes a trade deficit. figure 5-5 Real interest A Shift in the Inyestment Schedule in a Small Open 1. An increase investment schedule from /(r)1to In Investment I(r)2 increases the amount of in- vestment at the world interest rate r. As a result. investment now exceeds saving, which 2. eads to means the economy is borrowing trade deficit from abroad and running a trade I (r) Investment, Saving, I,S Evaluating Economic Policy Our model of the open economy shows that the fow of goods and services mea- sured by the trade balance is inextricably connected to the international How of funds for capital accumulation. The net capital outflow is the difference between domestic saving and domestic investment. Thus, the impact of economic policies on the trade balance can always be found by examining their impact on dome tic saving and domestic investment. Policies that increase investment or decrease saving tend to cause a trade deficit, and policies that decrease investment or in tend to de surplu User JoENA: Job EFFo1460: 6264_ ch05: Pg 124: 26249#/eps at 100s wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 124:26249#/eps at 100% *26249* Wed, Feb 13, 2002 9:26 AM abroad, the domestic saving and investment schedules remain the same.The only change is an increase in the world interest rate from r 1 * to r 2 *.The trade balance is the difference between the saving and investment schedules; because saving exceeds investment at r 2 *, there is a trade surplus. Hence, an increase in the world interest rate due to a fiscal expansion abroad leads to a trade surplus. Shifts in Investment Demand Consider what happens to our small open economy if its investment schedule shifts outward—that is, if the demand for investment goods at every interest rate increases.This shift would occur if, for example, the government changed the tax laws to encourage investment by providing an investment tax credit. Figure 5-5 illustrates the impact of a shift in the investment schedule.At a given world interest rate, investment is now higher. Because saving is unchanged, some investment must now be financed by borrowing from abroad, which means the net capital outflow is negative. Put differently, because NX = S − I, the increase in I implies a decrease in NX. Hence, an outward shift in the investment schedule causes a trade deficit. 124 | PART II Classical Theory: The Economy in the Long Run figure 5-5 Real interest rate, r r* NX S Investment, Saving, I, S I(r) 2 I(r) 1 1. An increase in investment demand . . . 2. . . . leads to a trade deficit. A Shift in the Investment Schedule in a Small Open Economy An outward shift in the investment schedule from I(r)1 to I(r)2 increases the amount of investment at the world interest rate r*. As a result, investment now exceeds saving, which means the economy is borrowing from abroad and running a trade deficit. Evaluating Economic Policy Our model of the open economy shows that the flow of goods and services measured by the trade balance is inextricably connected to the international flow of funds for capital accumulation.The net capital outflow is the difference between domestic saving and domestic investment.Thus, the impact of economic policies on the trade balance can always be found by examining their impact on domestic saving and domestic investment. Policies that increase investment or decrease saving tend to cause a trade deficit, and policies that decrease investment or increase saving tend to cause a trade surplus
Worth: Mankiw Economics 5e CHAPTER 5 The Open Economy |125 Our analysis of the open economy has been positive, not normative. Th our analysis of how economic policies influence the international flows of capi- tal and goods has not told us whether these policies are desirable. Evaluating eco- nomic policies and their impact on the open economy is a frequent topic of debate among economists and policymakers When a country runs a trade deficit, policymakers must confront the question of whether it represents a national problem. Most economists view a trade deficit not as a problem in itself, but perhaps as a symptom of a problem. a trade deficit could be a reflection of low saving In a closed economy, low saving leads to low investment and a smaller future capital stock. In an open economy, low saving leads to a trade deficit and a growing foreign debt, which eventually must be re- tion, Implying that future generations bear the burden of low national saving R paid. In both cases, high current consumption leads to lower future consun rural economies develop into modern industrial economies, they sometimes & A Yet trade deficits are not always a reflection of economic malady. When po nance their high levels of investment with foreign borrowing. In these cases, trade deficits are a sign of economic development. For example, South Korea ran large trade deficits throughout the 1970s, and it became one of the success stories of economic growth. The lesson is that one cannot judge economic performance from the trade balance alone. Instead, one must look at the underlying causes of the international flows The U.s. trade deficit During the 1980s and 1990s, the United States ran large trade deficits. Panel (a) of Figure 5-6 documents this experience by showing net exports as a percentage of GDP. The exact size of the trade deficit fluctuated over time, but it was large throughout these two decades. In 2000, the trade deficit was $371 billion, or 3.7 percent of GDP. As accounting identities require, this trade deficit had to be fi nanced by borrowing from abroad (or, equivalently, by selling U.S. assets abroad) During this period, the United States went from being the worlds largest credi- tor to the worlds largest debtor Q What caused the U.S. trade deficit? There is no single explanation. But to un- rstand some of the forces at work, it helps to look at national saving and do- mestic investment, as shown in panel() of the figure. Keep in mind that the trade deficit is the difference between saving and investment The start of the trade deficit coincided with a fall in national saving. This de- velopment can be explained by the expansionary fiscal policy in the 1980s. With the support of President Reagan, the U.S. Congress passed legislation in 1981 that substantially cut personal income taxes over the next three years. Because these tax cuts were not met with equal cuts in government spending, the federal budget went into deficit. These budget deficits were among the largest ever ex- perienced in a period of peace and prosperity, and they continued long after Reagan left office. According to our model, such a policy should reduce national User JOENA: Job EFF01460: 6264_ch05: Pg 125: 26250#/eps at 100s Wed,Feb13,20029:27
User JOEWA:Job EFF01460:6264_ch05:Pg 125:26250#/eps at 100% *26250* Wed, Feb 13, 2002 9:27 AM Our analysis of the open economy has been positive, not normative.That is, our analysis of how economic policies influence the international flows of capital and goods has not told us whether these policies are desirable. Evaluating economic policies and their impact on the open economy is a frequent topic of debate among economists and policymakers. When a country runs a trade deficit, policymakers must confront the question of whether it represents a national problem. Most economists view a trade deficit not as a problem in itself, but perhaps as a symptom of a problem. A trade deficit could be a reflection of low saving. In a closed economy, low saving leads to low investment and a smaller future capital stock. In an open economy, low saving leads to a trade deficit and a growing foreign debt, which eventually must be repaid. In both cases, high current consumption leads to lower future consumption, implying that future generations bear the burden of low national saving. Yet trade deficits are not always a reflection of economic malady.When poor rural economies develop into modern industrial economies, they sometimes fi- nance their high levels of investment with foreign borrowing. In these cases, trade deficits are a sign of economic development. For example, South Korea ran large trade deficits throughout the 1970s, and it became one of the success stories of economic growth.The lesson is that one cannot judge economic performance from the trade balance alone. Instead, one must look at the underlying causes of the international flows. CHAPTER 5 The Open Economy | 125 CASE STUDY The U.S. Trade Deficit During the 1980s and 1990s, the United States ran large trade deficits. Panel (a) of Figure 5-6 documents this experience by showing net exports as a percentage of GDP.The exact size of the trade deficit fluctuated over time, but it was large throughout these two decades. In 2000, the trade deficit was $371 billion, or 3.7 percent of GDP. As accounting identities require, this trade deficit had to be fi- nanced by borrowing from abroad (or, equivalently, by selling U.S. assets abroad). During this period, the United States went from being the world’s largest creditor to the world’s largest debtor. What caused the U.S. trade deficit? There is no single explanation. But to understand some of the forces at work, it helps to look at national saving and domestic investment, as shown in panel (b) of the figure. Keep in mind that the trade deficit is the difference between saving and investment. The start of the trade deficit coincided with a fall in national saving.This development can be explained by the expansionary fiscal policy in the 1980s.With the support of President Reagan, the U.S. Congress passed legislation in 1981 that substantially cut personal income taxes over the next three years. Because these tax cuts were not met with equal cuts in government spending, the federal budget went into deficit.These budget deficits were among the largest ever experienced in a period of peace and prosperity, and they continued long after Reagan left office. According to our model, such a policy should reduce national
Worth: Mankiw Economics 5e 126 PART 11 Classical Theory: The Economy in the Long Run (a) The U.S. Trade Balance Percentage of gDp Deficit Trade balance 196019651970197519801985199019952000 (b)U.S Saving and Investment of gDP 18 19601965197019751980198519901995 The Trade Balance, Saving, and Investment: The U.S. Experience Panel(a) shows the trade balance as a percentage of GDP. Positive numbers represent a surplus, and negative numbers represent a deficit. Panel (b)shows national saving and ivestment as a percentage of GDP since 1960. The trade balance equals saving Source: U.S. Department of Commerce. User JOENA: Job EFF01460: 6264_ch05: Pg 126: 26251#/eps at 100s Wed,Feb13,20029:27
User JOEWA:Job EFF01460:6264_ch05:Pg 126:26251#/eps at 100% *26251* Wed, Feb 13, 2002 9:27 AM 126 | PART II Classical Theory: The Economy in the Long Run figure 5-6 Percentage of GDP Investment Saving 2 1 0 21 22 23 24 25 Surplus Deficit 1960 1965 Year 1970 1975 1980 1985 1990 1995 2000 Percentage of GDP 1960 Year 20 19 18 17 16 15 14 13 12 11 10 (b) U.S. Saving and Investment (a) The U.S. Trade Balance 1965 1970 1975 1980 1985 1990 1995 2000 Trade balance The Trade Balance, Saving, and Investment: The U.S. Experience Panel (a) shows the trade balance as a percentage of GDP. Positive numbers represent a surplus, and negative numbers represent a deficit. Panel (b) shows national saving and investment as a percentage of GDP since 1960. The trade balance equals saving minus investment. Source: U.S. Department of Commerce
Worth: Mankiw Economics 5e CHaPter 5 The aving, thereby causing a trade deficit. And, in fact, that is exactly what happened Because the government budget and trade balance went into deficit at roughly the same time, these shortfalls were called the twin deficits Things started to change in the 1990s, when the U.S. federal government got its fiscal house in order. The first President Bush and President Clinton both signed tax increases, while Congress kept a lid on spending. In addition to these policy changes, rapid productivity growth in the late 1990s raised in- comes and, thus, further increased tax revenue. These developments moved the U.S. federal budget from deficit to surplus, which in turn caused national sav- ng to rise In contrast to what our model predicts, the increase in national saving did not oincide with a shrinking trade deficit, because domestic investment rose at the same time. The likely explanation is that the boom in information technology caused an expansionary shift in the U.S. investment function. Even though fiscal policy was pushing the trade deficit toward surplus, the investment boom was an even stronger force pushing the trade balance toward deficit The history of the U.S. trade deficit shows that this statistic, by itself, does not tell much about what is happening in the economy. We have to look deeper at sav ing, investment, and the policies and events that cause them to change over time 5-3 Exchange Rates Having examined the international flows of capital and of goods and services, we now extend the analysis by considering the prices that apply to these transac- tions. The exchange rate between two countries is the price at which residents of those countries trade with each other. In this section we first examine precisely what the exchange rate measures, and we then discuss how exchange rates are determined Nominal and Real Exchange Rates Economists distinguish between two exchange rates: the nominal exchange rate and the real exchange rate. Let's discuss each in turn and see how they are The Nominal Exchange Rate The nominal exchange rate is the relative price of the currency of two countries. For example, if the exchange rate be- tween the U.S. dollar and the Japanese yen is 120 yen per dollar, then you can ex- change one dollar for 120 yen in world markets for foreign currency. A Japanese who wants to obtain dollars would pay 120 yen for each dollar he bought. An American who wants to obtain yen would get 120 yen for each dollar he paid. When people refer to "the exchange rate"between two countries, they usually mean the nominal exchange rate User JoNA:JobE01460:6264ch05:9127:262524#/epat100|ll Wed,Feb13,20029:27
User JOEWA:Job EFF01460:6264_ch05:Pg 127:26252#/eps at 100% *26252* Wed, Feb 13, 2002 9:27 AM 5-3 Exchange Rates Having examined the international flows of capital and of goods and services, we now extend the analysis by considering the prices that apply to these transactions.The exchange rate between two countries is the price at which residents of those countries trade with each other. In this section we first examine precisely what the exchange rate measures, and we then discuss how exchange rates are determined. Nominal and Real Exchange Rates Economists distinguish between two exchange rates: the nominal exchange rate and the real exchange rate. Let’s discuss each in turn and see how they are related. The Nominal Exchange Rate The nominal exchange rate is the relative price of the currency of two countries. For example, if the exchange rate between the U.S. dollar and the Japanese yen is 120 yen per dollar, then you can exchange one dollar for 120 yen in world markets for foreign currency. A Japanese who wants to obtain dollars would pay 120 yen for each dollar he bought. An American who wants to obtain yen would get 120 yen for each dollar he paid. When people refer to “the exchange rate’’ between two countries, they usually mean the nominal exchange rate. CHAPTER 5 The Open Economy | 127 saving, thereby causing a trade deficit. And, in fact, that is exactly what happened. Because the government budget and trade balance went into deficit at roughly the same time, these shortfalls were called the twin deficits. Things started to change in the 1990s, when the U.S. federal government got its fiscal house in order. The first President Bush and President Clinton both signed tax increases, while Congress kept a lid on spending. In addition to these policy changes, rapid productivity growth in the late 1990s raised incomes and, thus, further increased tax revenue.These developments moved the U.S. federal budget from deficit to surplus, which in turn caused national saving to rise. In contrast to what our model predicts, the increase in national saving did not coincide with a shrinking trade deficit, because domestic investment rose at the same time. The likely explanation is that the boom in information technology caused an expansionary shift in the U.S. investment function. Even though fiscal policy was pushing the trade deficit toward surplus, the investment boom was an even stronger force pushing the trade balance toward deficit. The history of the U.S.trade deficit shows that this statistic,by itself,does not tell us much about what is happening in the economy. We have to look deeper at saving, investment, and the policies and events that cause them to change over time