1Chapter Five

The Open Economy

Chapter 8 - Mankiw

2Chapter Five

• Until now: closed economy• In reality, most economies are open:

- export goods and services abroad

- import goods and services from abroad

- borrow and lend in financial markets

• Some empirical evidence:

- in US, imports and exports are about 13% of GDP

- in Canada and United Kingdom, imports and exports are over 30% of GDP

- in Netherlands or Belgium (smaller countries), exports are more than 50% of GDP

3Chapter Five

This part: Open-Economy Macroeconomics

1) How to measure the interactions among countries (flows of goods and services and flows of funds)

(the accounting identities)

2) The determinants of these international flows

(a model of a small open economy)

3) Exchange rates (the prices at which a country makes exchanges in the world markets)

4Chapter Five

• Closed economy

- all output is sold domestically

- expenditure is divided into:• consumption (C)• investment (I)• government purchases (G)

• Open economy

- some output is sold domestically and some is exported to be sold abroad

- expenditure is divided

into:• consumption (Cd)• investment (Id)• government purchases (Gd) • exports of domestic goods and

services (EX)

5Chapter Five

Governmentpurchases of goods

and services

Governmentpurchases of goods

and services

Y = C + I + G + NXY = C + I + G + NX

Total demandfor domestic

output

Total demandfor domestic

output

Consumptionspending byhouseholds

Consumptionspending byhouseholds

Investmentspending by

businesses andhouseholds

Investmentspending by

businesses andhouseholds

Net exportsor net foreign

demand

Net exportsor net foreign

demand

Notice we’ve added net exports, NX, defined as EX-IM. Also, note that domestic spending on all goods and services is the sum of domestic spending on domestic goods and services and on foreign goods and services.

is composed of

is composed of

6Chapter Five

Y = C + I + G + NXY = C + I + G + NXAfter some manipulation, the national income accounts identity can be re-written as:

NX = Y - (C + I + G)NX = Y - (C + I + G)

Net ExportsNet Exports OutputOutput

This equation shows that in an open economy, domestic spending need not equal the output of goods and services. If output exceeds domestic spending, we export the difference: net exports are positive. If output falls short of domestic spending, we import the difference: net exports are negative.

Domestic Spending

Domestic Spending

7Chapter Five

Start with the national income accounts identity. Y=C+I+G+NX.Subtract C and G from both sides and obtain Y-C-G = I+NX.

Let’s call this S, national saving (Review Chapter 3!!).

So, now we have S=I+NX. Subtract I from both sides to obtain the new equation, S-I=NX.This form of the national income accounts identity shows that an economy’s net exports must always equal the difference between its saving and its investment.

S-I=NX

Trade Balance(net exports)Net Foreign Investment

8Chapter Five

S-I=NXS-I=NXIf S-I and NX are positive, we have a trade surplus. We would be net lenders in world financial markets, and we are exporting more goods than we are importing.

If S-I and NX are negative, we have a trade deficit. We would be net borrowers in world financial markets, and we are importing more goods than we are exporting.

If S-I and NX are exactly zero, we have balanced trade since the value of imports equals the value of exports.

Net Capital Outflow = Trade Balance

It reflects the international flow of funds to finance capital accumulation

9Chapter Five

Until now, we have just defined some of the variables that measure interactions among countries.

We are now going to develop a model of the international flows of capital and goods, that will explain the behavior of these variables. Then, we’ll

address issues such as how the trade balance responds to changes in policy.

10Chapter Five

- We’ll borrow a part of the model from Chapter 3, but won’t assume that the real interest rate equilibrates saving and investment. - Instead, we’ll allow the economy to run a trade deficit and borrow from other countries, or to run a trade surplus and lendto other countries.

Assumptions:- Consider a small open economy with perfect capital mobility, which it takes the world interest rate r* as given, denoted r = r*.

-Our small open economy takes the world interest rate as an exogenously given variable

11Chapter Five

C = C (Y-T)

I = I (r)

Y = Y = F(K,L)

NX = (Y-C-G) - I or NX = S - I

The economy’s output Y is fixed by thefactors of production and the productionfunction.Consumption is positively related to disposable income (Y-T).Investment is negatively related to thereal interest rate.The national income accounts identity,expressed in terms of saving and investment.

Now substitute our three assumptions from Chapter 3 and the conditionthat the interest rate equals the world interest rate, r*.

NX = (Y-C(Y-T) - G) - I (r*)NX = S - I (r*)

This equation suggests that the trade balance is determined by thedifference between saving and investment at the world interest rate.

12Chapter Five

S

I(r)

Investment, Saving, I, S

Real interest rate, r*

rclosed

r*

NX

In a closed economy, r adjusts to equilibrate saving and investment.

In a small open economy, the interest rate is set by worldfinancial markets. The differencebetween saving and investmentdetermines the trade balance.

In this case, since r* is above rclosed and saving exceeds investment, there is a trade surplus (S>I).

r*'NX

If the world interest rate decreased to r* ', I would exceed S and there would be a trade deficit (S<I).

13Chapter Five

The impact of economic policies on the trade balance the impact of economic policies on domestic saving and domestic investment.

We will consider the following three situations:

- a domestic fiscal expansion

- a fiscal expansion abroad

- a shift in the investment demand

14Chapter Five

S

I(r)

Investment, Saving, I, S

Real interest rate, r*

r*

S'

Suppose: the economy begins in a position of balanced trade.An increase in (domestic) government purchases or a cut in taxes decreases national saving and thus shifts the national saving schedule to the left.

NX

The result is a reduction in national saving which leads to a trade deficit, where I > S.

NX = (Y-C(Y-T) - G) - I (r*)

NX = S - I (r*)

15Chapter Five

S

I(r)

Investment, Saving, I, S

Real interest rate, r*

r1*

What happens to a small open economy when foreign governments increase their government purchases? - If these countries are large enough to influence world saving and investment then the world interest rate raises from r1* to r2*.

NX

The higher world interest rate reduces investment in this small open economy, causing a trade surpluswhere S > I.

r2*

16Chapter Five

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*.

NX

As a result, investment now exceeds saving I > S, which means the economy isborrowing from abroad and running a trade deficit.

S

I(r)1

Investment, Saving, I, S

Real interest rate, r*

r1* I(r)2

17Chapter Five

To summarize:

• Policies that decrease saving or increase investment tend to cause a trade deficit

• Policies that increase saving or decrease investment tend to cause a trade surplus

18Chapter Five

In the next few slides, we’ll learn about the foreign exchange market, exchange rates and much more!

19Chapter Five

- two countries (US and Japan) engage in trade: different cultures, languages, and currencies, all of which could hinder trade.

- because of the foreign exchange market, trade transactions become more efficient. - The foreign exchange market is a global market in which banks are connected through high-tech telecommunications systems in order to purchase currencies for their customers.

20Chapter Five

it must supply yen which are then converted into dollars by the foreign exchange market.

ForeignExchange

Market

ForeignExchange

Market

Supply$DemandYEN

Demand$SupplyYEN

In order for Japan to pay for its imports of goods and services and securities from the U.S.,

In order for the U.S to pay for its imports of goods and services and securities from Japan,it must supply dollars which are then converted

into yen by the foreign exchange market.

& SecuritiesGOODS & SERVICES

GOODS & SERVICES

Goods and Services& SECURITIES

SECURITIES

21Chapter Five

The exchange rate between two countries is the price at whichresidents of those countries trade with each other.

22Chapter Five

-relative price of the currency of two countries-denoted as e -relative price of the currency of two countries-denoted as e

-relative price of the goods of two countries-sometimes called the terms of trade-denoted as

-relative price of the goods of two countries-sometimes called the terms of trade-denoted as

23Chapter Five

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 1 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.

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 1 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.

24Chapter Five

The real exchange rate is the relative price of the goods of two countries. The real exchange rate tells us the rate at which we can trade the goods of one country for the goods of another.

The difference between the real and nominal exchange rates:- consider a single good produced in many countries: cars.-suppose an American car costs $10,000 and a similar Japanese car costs 2,400,000 yen. - if a dollar is worth 120 yen, then the American car costs 1,200,000 yen. - Comparing the price of the American car (1,200,000 yen) and the price of the Japanese car (2,400,000 yen), we conclude that the American car costs one-half of what the Japanese car costs. - In other words, at current prices, we can exchange 2 American cars for 1 Japanese car.

25Chapter Five

We can summarize our calculation as follows:Real Exchange Rate = (120 yen/dollar) (10,000 dollars/American car)

(2,400,000 yen/Japanese Car) = 0.5 Japanese Car

American CarAt these prices, and this exchange rate, we obtain one-half of a Japanesecar per American car. More generally, we can write this calculation as Real Exchange Rate =

Nominal Exchange Rate Price of Domestic Good Price of Foreign Good

The rate at which we exchange foreign and domestic goods depends onthe prices of the goods in the local currencies and on the rate at whichthe currencies are exchanged.

26Chapter Five

= e × (P/P*)

Real Exchange Rate

Nominal Exchange

RateRatio of Price

Levels

Note: P is the price level of the domestic country (measured in the domestic currency) and P* is the price level of the foreign country (measured in the foreign currency).

27Chapter Five

= e × (P/P*)

The real exchange rate between two countries is computed from the nominal exchange rate and the price levels in the two countries.

If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive.

If the real exchange rate is low, foreign goods are relatively expensive, and domestic goods are relatively cheap.

Real Exchange Rate

Nominal Exchange Rate

Ratio of Price Levels

28Chapter Five

NX()

Net Exports, NX

Real exchangerate,

0

The real exchange rate is determined by theintersection of the vertical line representingsaving minus investment and downward-slopingnet exports schedule.

S-I

The relationship between the real exchange rate and net exports is negative: the lower the real exchange rate, the less expensive are domestic goods relative to foreign goods, and thus the greater are our net exports.

Here the quantity of dollars supplied for net foreigninvestment equals the quantity of dollars demandedfor the net exports of goods and services.

29Chapter Five

NX()

Net Exports, NX

Real exchangerate,

NX1

The fall in saving reduces the supply of dollarsto be exchanged into foreign currency, fromS1-I to S2-I. This shift raises the equilibrium realexchange rate from 1 to 2.

S1-I Expansionary fiscal policy at home, such as anincrease in government purchases G or a cut intaxes, reduces national saving.

A reduction in saving reduces the supply of dollars which causes the real exchange rate to rise and causes net exports to fall.

S2-I

NX2

2

1

30Chapter Five

NX()

Net Exports, NX

Real exchangerate,

NX2

The increase in the world interest rate reducesinvestment at home, which in turn raises thesupply of dollars to be exchanged into foreigncurrencies.

S-I (r2*)Expansionary fiscal policy abroad reduces world saving and raises the world interest rate from r1* to r2*.

As a result, the equilibriumreal exchange rate falls from 1 to 2.

NX1

1

2

S-I(r1*)

31Chapter Five

NX()

Net Exports, NX

Real exchangerate,

NX1

As a result, the supply of dollars to be exchanged into foreign currencies falls from S-I1 to S-I2.

S-I1An increase in investment demand raises the quantity of domestic investment from I1

to I2.

This fall in supply raises the equilibrium real exchange rate from 1 to 2.

NX2

1

2

S-I2

32Chapter Five

The law of one price - the same good cannot sell for different prices in different locations at the same time

Purchasing Power Parity - the law of one price applied to the international market place

- It states that if international arbitrage is possible, then a dollar must have the same purchasing power in every country.

- Purchasing Power Parity does not always hold because some goods are not easily traded, and sometimes traded goods are not always perfect substitutes– but it does give us reason to expect that fluctuations in the real exchange rate will be small and short-lived.

33Chapter Five

NX()

Net Exports, NX

Real exchangerate, e

The law of one price applied to the international marketplace suggests thatnet exports are highly sensitive to smallmovements in the real exchange rate.This high sensitivity is reflected herewith a very flat net-exports schedule.

S-I

34Chapter Five

Net exportsTrade balanceNet capital outflowTrade surplus and trade deficitBalanced tradeSmall open economyWorld interest rateNominal exchange rateReal exchange ratePurchasing-power parity