Class Notes Intermediate Macroeconomics Li Gan Lecture 5: Open Economy

Here are the exports and imports as percentages of the GDP. Some what surprisingly, according to this measure, Japan and the US are the countries with the least international trade.

Trade of the United States: in 2007, GDP is 13.84 trillion Export: 2.346 trillion, 16.95% of GDP Import: 1.646 trillion, 11.89% of GDP Trade deficit: 700.3 billion The following graphs show exports of imports by major categories.

• For Services, US has trade surplus in travel and in other private services.

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US Export/Import (Services, 2008)

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• For goods, US has substantial deficits in industrial supplies and in consumer

goods. US has a slight trade surplus in foods and beverages, and in capital goods.

US Export/Import (Goods, 2008)

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Foods, Feeds,& Beverages

IndustrialSupplies (2)

Capital Goods AutomotiveVehicles, etc.

ConsumerGoods

Other Goods

ExportImport

Example: US and China trade

• China: in 2007, GDP is 3.251 trillion

Export 1.22 trillion, 37.5% of GDP Import 956 billion, 29.4% of GDP

Trade surplus 262.2 billion

• US China (2007): Export: 65.24 billion Import: 321.4 billion Trade deficit: -256.2 billion

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Trade between US and China

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1988 1993 1998 2003 2008

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importsurplus

Exchange Rate (Chinese Yuan/US $)

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1985 1990 1995 2000 2005 2010

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• During last twenty years, the trades between US and China have grown exponentially. The US export to China has grown 13 times, and US import from China has grown by 39 times.

• US has a substantial trade deficit 256.2 billion with China. 36.7% of the US total

trade deficit is with China. Almost the entire trade China’s trade surplus is with the US.

• It is unlikely the trade deficit with China is due to the exchange rates. The nominal exchange rate between US $ and Yuan has first appreciated substantially before 1994, and remain constant for about 10 years, and depreciated after 2005. The trade deficits and total volumes of trade have not been affected by the changes of nominal exchange rates.

Why trade? Comparative advantages.

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How is the pattern of trade determined? To understand how trade is determined, we start with the GDP equation:

Y = C + I + G + NX Y – C – G = I + NX S = I + NX Or, S – I = NX Net capital outflow = Net exports

Example: Bill Gates sells a copy of windows to a Japanese consumer for 5,000 yen.

Net export increases by 5,000 yen How would he use this 5,000 yen?

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(1) If he uses the 5,000 yen to invest in Japan by buying stocks of Sony corporation, or by deposit into a Japanese bank net capital flow increases (some of the US saving is flowing abroad).

(2) Instead of investment his 5,000 yen, he uses this to buy something made in Japan, like Sony Walkman import increases by 5,000 yen. No change in net export.

(3) He changes the 5,000 Yen into US dollar. The bank has either buy Japanese stocks or deposit into a Japanese bank, or has to exchange the Yen into dollar with somebody else.

Saving and investment in an Open Economy Assumptions:

(i) Fixed output. (ii) C = C(Y-T) = a + b(Y-T) (iii) I = I(r)

Interest rate is internationally determined: r = r*

NX = S – I = Y – C(Y-T) – G – I(r*)

However, if G increases S decreases S curves shifts left trade deficit.

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A higher G would lead to a larger trade deficit Twin Deficits (budget deficit + trade deficit). See the following graph:

If world interest rate goes up trade surplus. For example, Obama, at the G20 meeting, pushes for other countries to increase the fiscal stimulus – why? Because some of the stimulus in the US may not work if the consequence of this is to increase the trade deficit.

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Exchange rates

Real exchange rate = nominal exchange rate x price of domestic good / price of foreign good Or:

Real exchange rate = Normal exchange rate * Ratio of price levels

*PPe×=ε

Example: On 2/4/2009, Price of Big Mac 290 Yen in Japan, and 12.5 Yuan in China. Price of Big Mac in US is 3.54. The nominal exchange rate is: 100 Yen/$, 6.83 Yuan/$ Real exchange rate b/w US and Japan = 100 * 3.54/290 = 1.22 Real exchange rate b/w US and China = 6.83 * 3.54/12.5 = 1.93 Big Mac is 22% more expensive in US than in Japan, and 93% more expensive in US than in China. Obviously, the net export depends on the real exchange rate: NX(ε). Higher real exchange rate, lower the net trade balance. Rewrite previous model, S – I = NX(ε)

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Fiscal policy: increase G lower NX (twin deficits again).

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Determinants of Nominal Exchange Rates:

PPe

*

×= ε

Changes in normal exchange rates (log difference): % change in nominal = % change in real exchange rate + % change in P* - % change in P % change in nominal = % in real + difference in inflation The following data (over the period of 1972-2004)

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Purchasing Power Parity (Law of one Price) The strong version of PPP: real change rate = 1 The weaker version of PPP: change in real change rate = 0 Big Mac Index The next table is the well-known Big Mac Prices at: 02/04/2009 This index has its own advantages and disadvantages. Advantages:

• One of the problems when obtaining the real exchange rate is the quality difference of the same good at different countries. However, the Big Mac can solve this problem because the Big Mac across countries should be the same.

• Another advantage of the Big Mac is the coverage of countries. The McDonald’s

has branches in almost all countries, so almost all countries would have the same Big Mac.

Disadvantages:

• Using Big Mac is also problematic. The Big Mac is essentially a non-tradable good. But we know the trade would ensure the PPP for tradable goods, not necessarily for non-tradable goods. For example, housing (non-tradable goods) prices in California and in Texas differ substantially. The PPP between the “California dollar” and “Texas dollar” should obviously be true.

Example of the Big Mac index:

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For Norway: 1612.04054.3*91.6* <=== −−

Norway

USUSNorwayUSNorway P

Peε .

For China: 1937.15.12

54.3*84.6* >=== −−China

USUSChinaUSChina P

Peε

If we assume the real exchange is to be one, we could derive the Big Mac exchange rate:

For Norway: 91.629.1154.3

40>===−

−US

NorwayMacBigUSNorway P

Pe Norway Kroner is over-valued.

For China: 84.653.354.35.12

<===−−

US

ChinaMacBigUSChina P

Pe Chinese Yuan is under-valued.

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