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Birks – Mankiw Chapter 31: Open-Economy Macroeconomics: Basic Concepts

A commentary on Mankiw Chapter 31: Open-Economy Macroeconomics: Basic Concepts (Mankiw 7th edition)

Mankiw, N. G. (2015) Principles of economics (7th ed.) Ch.31
Principles of macroeconomics
(7th ed.) Ch.18
Mason, OH: South-Western Cengage Learning

Open-Economy Macroeconomics: Basic Concepts

When reading the chapter, here are some aspects to consider:

1. Mankiw begins the chapter with the claim that international trade can make everyone better off. This is based on the ability of trade to allow positions to be achieved that are outside a country’s production possibility frontier. Using comparative static analysis, we can see that a country fully adjusted to a situation with international trade has more options than one without international trade. It compares the situations purely in terms of available goods and services. It says nothing about the differing types of work involved, environmental impacts of those patterns of production, differences in economic, political or strategic vulnerability, how the gains may be spread (who gains and who loses), or the adjustment process moving to a situation with international trade and the time and cost of this adjustment. For an indication of some of the factors not mentioned, consider this quote (emphasis added) on the process of transition from a fairly traditional (non-industrialised) economy attempting to “take off” to become a modern economy:

“In a larger sense, however, the experience of take-off appears, on present evidence, to be a definitive transition, like the loss of innocence. The reason for this judgment is that behind the whole industrial process lies the acceptance of the Newtonian outlook, the acceptance of the world of modern science and technology…[I]t appears to be the case that the larger psychological, social, technological, and institutional changes required for a take-off are such as to make it unlikely that there will be a true lapsing back. The deeper fundamentals required for an effective take-off appear sufficiently powerful to make growth an ongoing process, on long term; and, in the ruthless arena of world power, a slackening of effort, stagnation, or a drawing back have brought danger from those abroad who persisted and moved relatively ahead.”

(Rostow, 1971, p.100)

Also, in a perhaps telling point given recent experience in many countries, Linder (1977, p.250) describes “…the theory of comparative advantages, which decrees that in the long run it is better for a nation to sacrifice an entire industry in order to put its scarce resources to more efficient use.”

2. Mankiw gives a simplified representation of current transactions. In reality there are more than just exports and imports of goods and services to consider. There are also:

  1. net factor income from abroad. This refers to income earned from labour, capital and so on that is earning money in other countries. We are obtaining income from these, and overseas factors of production employed within our own country earn income which then goes overseas. An important component of this is remittances. These are highly significant for many Pacific Island countries, for example, and also for the Philippines, which has many workers earning money in other countries.
  2. transfers. These are payments made in one direction without services going in the reverse direction. For example, there are people who worked in one country and then retired to another, but still receive their pensions.

3. You should note the structure given in Mankiw when, for example, talking about determinants of exports and determinants of imports. He tends to take a fairly informal approach to these matters. For exam preparation, it would help for you to try to formalise it. You could consider exports as a function of the bullet-pointed variables, and similarly for imports. You could also consider in which way quantities of exports and imports would vary as those determining variables change.

4. There are also some useful points about the importance of deficits or surpluses and the implications that they have for capital movements. In general with Mankiw, it is worth identifying when he is describing a model and determining the assumptions on which the model is based. Economics commonly presents material by starting with a simple model with the assumptions clearly stated. Findings are then derived on the basis of that defined structure, after which the assumptions can be relaxed to make increasingly complex models. You are seeing this to some extent in Mankiw’s chapters already, when he started with a closed economy without international trade and now he is moving on to open economy models where international trade is being added in. This will become particularly significant by the time you move to the next chapter, which is developing these aspects further. There you have models and assumptions that are often hidden within the text. You should search for the assumptions. They are very important for determining the structure and the nature of the relationships and they should not be forgotten. The models do not refer to the real world directly, although they may have relevance for the real world.

5. We also see the determinants of capital flows. These could be treated in the same way as determinants of exports and imports. The flows are a function of these variables. Consider in which way the values would change as the variables change.

6. Note that overall, if we assume away the possibility of reserves of foreign currency, the balance of payments will always balance. We are thinking of either demand for and supply of your currency on world markets, or your country’s demand for and supply of foreign currency. There is a market and, with freely floating exchange rates, the market will be at equilibrium. Demand will equal supply. Demand is for current and capital purposes, and supply comes from current and capital purposes also. Consequently overall current and capital transactions will balance. If there is a surplus on one account, it will be balanced by a deficit on the other. A surplus on current account, for example, will be balanced by an equal reverse flow on the capital account.

7. On real and nominal exchange rates, it can help to think of the formula for the real exchange rate as being the nominal exchange rate multiplied by the ratio of domestic to foreign price levels. This is not exactly as Mankiw interprets it (despite his equation in section 2b), because the price levels are in relation to base years, so there is a scaling factor if the base years are not the same. For simplicity, just remember the formula and bear in mind that, if prices stay constant and the nominal exchange rate changes, there is a change in relative price of goods and hence a change in the real exchange rate. Alternatively, if the nominal exchange rate stays constant and one or other of the price levels changes then again, there is a change in the real exchange rate. So a change in the real exchange rate is determined by a combination of nominal exchange rate movements and relative price level movements. If you want to see what I mean by a scaling factor, read on:

A price index gives the current cost of the indexed basket of goods divided by the base year cost of that basket. We could think of Mankiw’s P and P* in section 2b as Pt/P0 and P*t/P*0. P/P* is therefore (Pt/P*t) x (P*0/P0). The first half of this term, (Pt/P*t) is the relative prices of the two baskets. They are in different currencies, hence Mankiw’s need to multiply by the exchange rate, e. The second half of this term, (P*0/P0), is a constant. Mankiw describes the formula as if the second term is not there. We should also note that the two baskets used to construct the price indices are not the same.

8. Where Mankiw talks about the effect of changes in the real exchange rate on exports and imports, note that he is describing changes in volumes of exports and imports. This does not tell us directly what is happening to levels of expenditure on these. Consequently, we cannot immediately determine the response he suggests in terms of the effect on net exports. Investigation of such issues should be reserved to more advanced courses, however. Therefore, it would make sense at this stage simply to treat Mankiw’s interpretation as sufficient.

9. The concept of purchasing power parity is based on a particular perspective, emphasising exchange rates being determined solely on the basis of (i) demand and supply of goods and services, and (ii) essentially costless transactions. If all goods could be traded, there are no transport costs and no goods are perishable (so they can all be transported from one place to another), and various other assumptions, then with perfect information we might find prices being equalised over all markets for the same good. However, this is not what we observe in the real world. Also currency movements occur for other purposes, and they can also have an impact on exchange rate. So we have a highly simplified perspective under the concept of purchasing power parity and the so-called law of one price. This is not so much a law as a conjecture as to something that might happen in a simplified world.

10. The hyperinflation example in Figure 3 may look plausible, but it could be that the relationship is so clear because of the extremes of the change in price level. With hyperinflation neither people within a country nor are people in other countries are likely to want their currency. We would therefore expect to see the observed effects both on the price level and on the exchange rate. In general, however, there may be a large number of different determinants of both inflation and exchange rates, and so the relationship between the two may be somewhat more confused.

Linder, M. (1977) The Anti-Samuelson Volume 2 Microeconomics: Basic problems of the capitalist economy, New York: Urizen Books

Rostow, W. W. (1971) Politics and the stages of growth, Cambridge [Eng.]: University Press.

Commentary by Stuart Birks, 4 September 2014

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