Mankiw Macroeconomics (5th ed)

C H A P T E R 5 The Open Economy | 149

The last variable we should consider is the nominal exchange rate. As before, the nominal exchange rate is the real exchange rate times the ratio of the price levels:

e = e × (P*/P).

The real exchange rate is determined as in Figure 5-18, and the price levels are determined by monetary policies here and abroad, as we discussed in Chapter 4. Forces that move the real exchange rate or the price levels also move the nominal exchange rate.

Policies in the Large Open Economy

We can now consider how economic policies influence the large open economy. Figure 5-19 shows the three diagrams we need for the analysis. Panel (a) shows the equilibrium in the market for loanable funds; panel (b) shows the relationship between the equilibrium interest rate and the net capital outflow; and panel (c) shows the equilibrium in the market for foreign exchange.

Fiscal Policy at Home Consider the effects of expansionary fiscal policy—an increase in government purchases or a decrease in taxes. Figure 5-20 shows what

f i g u r e 5 - 1 9

(a) The Market for Loanable Funds

Real interest
rate, r	S

I CF

Loanable funds, S, I CF

The Equilibrium in the Large Open Economy Panel (a) shows that the market for loanable funds determines the equilibrium interest rate. Panel (b) shows that the interest rate determines the net capital outflow, which in turn determines the supply of dollars to be exchanged into foreign currency. Panel

(c) shows that the real exchange rate adjusts to balance this supply of dollars with the demand coming from net exports.

(b) Net Capital Outflow

r

CF(r)

Net capital outflow, CF

(c) The Market for Foreign Exchange

Real

exchange

CF

rate, e

NX(e)

Net exports, NX

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150 | P A R T I I Classical Theory: The Economy in the Long Run

f i g u r e 5 - 2 0

(a) The Market for Loanable Funds
Real interest
rate, r			S
r2
		1. A
r1		fall in
		saving . . .
2. . . .
raises the				I CF
interest
rate, . . .			Loanable funds, S, I CF
	A Reduction in National Saving in the

Large Open Economy Panel (a) shows that a reduction in national saving lowers the supply of loanable funds. The equilibrium interest rate rises. Panel (b) shows that the higher interest rate lowers the net capital outflow. Panel (c) shows that the reduced capital outflow means a reduced supply of dollars in the market for foreign-currency exchange. The reduced supply of dollars causes the real exchange rate to appreciate and net exports to fall.

r

r2

r1

3. . . . which lowers net capital outflow, . . .

(b) Net Capital Outflow

			CF(r)
CF2		CF1	Net capital
			outflow, CF

(c) The Market for Foreign Exchange

Real

exchange CF rate, e e2

4. . . . e1 raises the exchange rate, . . .

NX(e)

5. . . . and

reduces NX2 NX1 Net exports, NX net exports.

happens. The policy reduces national saving S, thereby reducing the supply of loanable funds and raising the equilibrium interest rate r.The higher interest rate reduces both domestic investment I and the net capital outflow CF. The fall in the net capital outflow reduces the supply of dollars to be exchanged into foreign currency.The exchange rate appreciates, and net exports fall.

Note that the impact of fiscal policy in this model combines its impact in the closed economy and its impact in the small open economy. As in the closed economy, a fiscal expansion in a large open economy raises the interest rate and crowds out investment.As in the small open economy, a fiscal expansion causes a trade deficit and an appreciation in the exchange rate.

One way to see how the three types of economy are related is to consider the identity

S = I + NX.

In all three cases, expansionary fiscal policy reduces national saving S. In the closed economy, the fall in S coincides with an equal fall in I, and NX stays constant at zero. In the small open economy, the fall in S coincides with an equal fall

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C H A P T E R 5 The Open Economy | 151

in NX, and I remains constant at the level fixed by the world interest rate. The large open economy is the intermediate case: both I and NX fall, each by less than the fall in S.

Shifts in Investment Demand Suppose that the investment demand schedule shifts outward, perhaps because Congress passes an investment tax credit. Figure 5-21 shows the effect. The demand for loanable funds rises, raising the equilibrium interest rate.The higher interest rate reduces the net capital outflow:Americans make fewer loans abroad, and foreigners make more loans to Americans. The fall in the net capital outflow reduces the supply of dollars in the market for foreign exchange.The exchange rate appreciates, and net exports fall.

f i g u r e 5 - 2 1

(a) The Market for Loanable Funds

Real interest		S
rate, r
r2
r1	1. An
	increase
2. . . .
raises the	in investment
interest	demand . . .	I CF
rate, . . .

Loanable funds, S, I CF

An Increase in Investment Demand in the Large Open Economy Panel (a) shows that an increase in investment demand raises the interest rate. Panel

(b) shows that the higher interest rate lowers the net capital outflow. Panel (c) shows that a lower capital outflow causes the real exchange rate to appreciate and net exports to fall.

r

r2

r1

3. . . . which reduces net capital outflow, . . .

(b) Net Capital Outflow

			CF(r)
CF2		CF1	Net capital
			outflow, CF

(c) The Market for Foreign Exchange

Real

exchange CF

rate, e

e2

4. . . . e1 raises the

exchange rate, . . .

NX(e)

5. . . . and

reduces NX2 NX1 Net exports, NX net exports.

Trade Policies Figure 5-22 shows the effect of a trade restriction, such as an import quota. The reduced demand for imports shifts the net-exports schedule outward in panel (c). Because nothing has changed in the market for loanable funds, the interest rate remains the same, which in turn implies that the net capital outflow remains the same. The shift in the net-exports schedule causes the exchange rate to appreciate. The rise in the exchange rate makes U.S. goods

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152 | P A R T I I Classical Theory: The Economy in the Long Run

f i g u r e 5 - 2 2

(a) The Market for Loanable Funds

Real interest	S
rate, r

I CF

Loanable funds, S, I CF

An Import Restriction in the Large Open Economy An import restriction raises the demand for net exports, as shown in panel (c). The real exchange rate appreciates, while the equilibrium trade balance remains the same. Nothing happens in the market for loanable funds in panel (a) or to the net capital outflow in panel (b).

(b) Net Capital Outflow

r

CF(r)

Net capital outflow, CF

(c) The Market for Foreign Exchange

Real exchange rate, e e2

e1

2. . . . which increases the exchange rate, . . .

1. Protectionist policies raise the demand for net exports, . . .

NX(e)

2 1

Net exports, NX

3. . . . leaving net exports unchanged.

expensive relative to foreign goods, which depresses exports and stimulates imports. In the end, the trade restriction does not affect the trade balance.

Shifts in Net Capital Outflow There are various reasons that the CF schedule might shift. One reason is fiscal policy abroad. For example, suppose that Germany pursues a fiscal policy that raises German saving. This policy reduces the German interest rate. The lower German interest rate discourages American investors from lending in Germany and encourages German investors to lend in the United States. For any given U.S. interest rate, the U.S. net capital outflow falls.

Another reason the CF schedule might shift is political instability abroad. Suppose that a war or revolution breaks out in another country. Investors around the world will try to withdraw their assets from that country and seek a “safe haven” in a stable country such as the United States.The result is a reduction in the U.S. net capital outflow.

Figure 5-23 shows the impact of a shift in the CF schedule.The reduced demand for loanable funds lowers the equilibrium interest rate.The lower interest

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C H A P T E R 5 The Open Economy | 153

f i g u r e 5 - 2 3

(a) The Market for Loanable Funds

(b) Net Capital Outflow

Real interest rate, r

2. . . .

causes the interest rate to fall, . . .

1. A fall in

net

r

capital outflow . . .

r1

r2

I CF

CF(r)

Loanable funds, S, I CF

CF2

CF1

Net capital

outflow, CF

A Fall in the Net Capital Outflow in the

(c) The Market for Foreign Exchange

Large Open Economy Panel (a) shows

Real

that a downward shift in the CF sched-

e

exchange

ule reduces the demand for loans and

rate, e

thereby reduces the equilibrium inter-

3. . . . the

e2

e

est rate. Panel (b) shows that the level

exchange

of the net capital outflow falls. Panel

e1

rate to

(c) shows that the real exchange rate

rise, . . .

appreciates, and net exports fall.

4. . . . and

NX(e)

net exports

NX2

NX1

Net exports, NX

to fall.

rate tends to raise net capital outflow, but because this only partly mitigates the shift in the CF schedule, CF still falls.The reduced level of net capital outflow reduces the supply of dollars in the market for foreign exchange.The exchange rate appreciates, and net exports fall.

Conclusion

How different are large and small open economies? Certainly, policies affect the interest rate in a large open economy, unlike in a small open economy. But, in other ways, the two models yield similar conclusions. In both large and small open economies, policies that raise saving or lower investment lead to trade surpluses. Similarly, policies that lower saving or raise investment lead to trade deficits. In both economies, protectionist trade policies cause the exchange rate to appreciate and do not influence the trade balance. Because the results are so similar, for most questions one can use the simpler model of the small open economy, even if the economy being examined is not really small.

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154 | P A R T I I Classical Theory: The Economy in the Long Run

M O R E P R O B L E M S A N D A P P L I C A T I O N S

1.If a war broke out abroad, it would affect the U.S. economy in many ways. Use the model of the large open economy to examine each of the following effects of such a war.What happens in the United States to saving, investment, the trade balance, the interest rate, and the exchange rate? (To keep things simple, consider each of the following effects separately.)

a.The U.S. government, fearing it may need to enter the war, increases its purchases of military equipment.

b.Other countries raise their demand for hightech weapons, a major export of the United States.

c.The war makes U.S. firms uncertain about the future, and the firms delay some investment projects.

d.The war makes U.S. consumers uncertain about the future, and the consumers save more in response.

e.Americans become apprehensive about traveling abroad, so more of them spend their vacations in the United States.

f.Foreign investors seek a safe haven for their portfolios in the United States.

2.On September 21, 1995, “House Speaker Newt Gingrich threatened to send the United States into default on its debt for the first time in the nation’s history, to force the Clinton Administration to balance the budget on Republican terms” (New York Times, September 22, 1995, A1). That same day, the interest rate on 30-year U.S. government bonds rose from 6.46 to 6.55 percent, and the dollar fell in value from 102.7 to 99.0 yen. Use the model of the large open economy to explain this event.

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6		S I X
	C H A P T E R
	Unemployment

A man willing to work, and unable to find work, is perhaps the saddest

sight that fortune’s inequality exhibits under the sun.

— Thomas Carlyle

Unemployment is the macroeconomic problem that affects people most directly and severely. For most people, the loss of a job means a reduced living standard and psychological distress. It is no surprise that unemployment is a frequent topic of political debate and that politicians often claim that their proposed policies would help create jobs.

Economists study unemployment to identify its causes and to help improve the public policies that affect the unemployed. Some of these policies, such as job-training programs, assist people in finding employment. Others, such as unemployment insurance, alleviate some of the hardships that the unemployed face. Still other policies affect the prevalence of unemployment inadvertently. Laws mandating a high minimum wage, for instance, are widely thought to raise unemployment among the least skilled and experienced members of the labor force. By showing the effects of various policies, economists help policymakers evaluate their options.

Our discussions of the labor market so far have ignored unemployment. In particular, the model of national income in Chapter 3 was built with the assumption that the economy was always at full employment. In reality, of course, not everyone in the labor force has a job all the time: all free-market economies experience some unemployment.

Figure 6-1 shows the rate of unemployment—the percentage of the labor force unemployed—in the United States since 1948. Although the rate of unemployment fluctuates from year to year, it never gets even close to zero.The average is between 5 and 6 percent, meaning that about 1 out of every 18 people wanting a job does not have one.

In this chapter we begin our study of unemployment by discussing why there is always some unemployment and what determines its level. We do not study what determines the year-to-year fluctuations in the rate of unemployment until Part IV of this book, where we examine short-run economic fluctuations. Here we examine the determinants of the natural rate of unemployment—the average rate of unemployment around which the economy fluctuates.The natural

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156 | P A R T I I Classical Theory: The Economy in the Long Run

f i g u r e	6 - 1
Percent
unemployed
	10			Unemployment rate
	8
	6
	4							Natural rate
								of unemployment
	2
	0
	1945	1950	1955	1960	1965	1970	1975	1980	1985	1990	1995	2000
												Year

The Unemployment Rate and the Natural Rate of Unemployment in the United States There is always some unemployment. The natural rate of unemployment is the average level around which the unemployment rate fluctuates. (The natural rate of unemployment for any particular year is estimated here by averaging all the unemployment rates from ten years earlier to ten years later. Future unemployment rates are set at 5.5 percent.)

rate is the rate of unemployment toward which the economy gravitates in the long run, given all the labor-market imperfections that impede workers from instantly finding jobs.

6-1 Job Loss, Job Finding, and the Natural Rate of Unemployment

Every day some workers lose or quit their jobs, and some unemployed workers are hired.This perpetual ebb and flow determines the fraction of the labor force that is unemployed. In this section we develop a model of labor-force dynamics that shows what determines the natural rate of unemployment.1

We start with some notation. Let L denote the labor force, E the number of employed workers, and U the number of unemployed workers. Because every

1 Robert E. Hall, “A Theory of the Natural Rate of Unemployment and the Duration of Unemployment,’’ Journal of Monetary Economics 5 (April 1979): 153–169.

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C H A P T E R 6 Unemployment | 157

worker is either employed or unemployed, the labor force is the sum of the employed and the unemployed:

L = E + U.

In this notation, the rate of unemployment is U/L.

To see what determines the unemployment rate, we assume that the labor force L is fixed and focus on the transition of individuals in the labor force between employment and unemployment.This is illustrated in Figure 6-2. Let s denote the rate of job separation, the fraction of employed individuals who lose their job each month. Let f denote the rate of job finding, the fraction of unemployed individuals who find a job each month.Together, the rate of job separation s and the rate of job finding f determine the rate of unemployment.

If the unemployment rate is neither rising nor falling—that is, if the labor market is in a steady state—then the number of people finding jobs must equal the number of people losing jobs. The number of people finding jobs is f U and the number of people losing jobs is sE, so we can write the steady-state condition as

f U = sE.

We can use this equation to find the steady-state unemployment rate. From an earlier equation, we know that E = L − U; that is, the number of employed equals the labor force minus the number of unemployed. If we substitute (L − U ) for E in the steady-state condition, we find

f U = s(L − U ).

f i g u r e 6 - 2

Job Separation (s)

Employed

Unemployed

Job Finding (f )

The Transitions Between Employment and Unemployment In every period, a fraction s of the employed lose their jobs, and a fraction f of the unemployed find jobs. The rates of job separation and job finding determine the rate of unemployment.

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158 | P A R T I I Classical Theory: The Economy in the Long Run

To get closer to solving for the unemployment rate, divide both sides of this equation by L to obtain

f U = s(1 − U ).

L			L
Now we can solve for U/L to find
	U	=	s	.
	L		s + f

This equation shows that the steady-state rate of unemployment U/L depends on the rates of job separation s and job finding f. The higher the rate of job separation, the higher the unemployment rate. The higher the rate of job finding, the lower the unemployment rate.

Here’s a numerical example. Suppose that 1 percent of the employed lose their jobs each month (s = 0.01).This means that on average jobs last 100 months, or about 8 years. Suppose further that about 20 percent of the unemployed find a job each month ( f = 0.20), so that spells of unemployment last 5 months on average.Then the steady-state rate of unemployment is

U =		0.01
L		0.01 +	0.20
= 0.0476.

The rate of unemployment in this example is about 5 percent.

This model of the natural rate of unemployment has an obvious but important implication for public policy. Any policy aimed at lowering the natural rate of unemployment must either reduce the rate of job separation or increase the rate of job finding. Similarly, any policy that affects the rate of job separation or job finding also changes the natural rate of unemployment.

Although this model is useful in relating the unemployment rate to job separation and job finding, it fails to answer a central question: Why is there unemployment in the first place? If a person could always find a job quickly, then the rate of job finding would be very high and the rate of unemployment would be near zero.This model of the unemployment rate assumes that job finding is not instantaneous, but it fails to explain why. In the next two sections, we examine two underlying reasons for unemployment: job search and wage rigidity.

6-2 Job Search and Frictional Unemployment

One reason for unemployment is that it takes time to match workers and jobs. The equilibrium model of the aggregate labor market discussed in Chapter 3 assumes that all workers and all jobs are identical, and therefore that all workers are

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