The Open Economy

1
The Open Economy

• Chapter Five

2
Introduction

• Until now we simplified our analysis by assuming
  a closed economy (no trade with other countries).
• In reality most economies are open they export
  goods/services abroad, they import goods/services
  from abroad, and they borrow/lend in world
  financial markets.
• The first goal of this chapter is to learn the
  macroeconomic variables that measure the
  interactions among countries accounting
  identities will reveal that the flow of goods
  across borders equals the flow of funds to
  finance capital accumulation.
• The second goal is to develop a small open
  economy model to explain determinants of these
  international flows the model shows the factors
  that determine whether a country is a borrower or
  a lender in world markets and how policies affect
  the flows of capital and goods/services.
• The last goal is to explain the determinants of
  nominal and real exchange rates.

3
Imports and Exports as a percentage of output
2000
4
The International Flows of Capital and Goods

• Unlike in closed economies, a countrys spending
  need not equal its output of goods/services in an
  open economy.
• A country can spend more (less) than it produces
  by borrowing (lending) from abroad.
• In an open economy, some output is sold
  domestically and some is exported abroad divide
  Y into 4 components
• Cd consumption of domestic goods and services
• Id investment in domestic goods and services
• Gd government purchases of domestic goods and
  services
• EX exports of domestic goods and services
• Y Cd Id Gd EX (closed economy Y C I
  G)
• What part represents domestic spending on
  domestic goods/services? What part represents
  foreign spending on domestic goods/services?

5
The Role of Net Exports
superscripts d spending on domestic goods f
spending on foreign goods
Y (C Cf) (I If) (G Gf) EX ? Y
C I G EX (Cf If Gf) IM imports
Cf If Gf ? Y C I G EX - IM
6
The Role of Net Exports

• Net exports exports minus imports
  NX EX IM ? Y C I
  G NX
• This national income accounts identity shows how
  domestic output, domestic spending, and net
  exports are related
• NX Y (C I G )

This equation shows that in an open economy,
domestic spending need not equal total output.
If output exceeds (falls short of) domestic
spending, we export (import) the difference net
exports are positive (negative).
7
International Capital Flows and the Trade Balance

• Like a closed economy, financial and goods
  markets are closely related in an open economy
  to see this rewrite the accounting identity in
  terms of saving and investment.
• Y C G I NX national saving is the sum of
  private saving Sp Y T C and public saving
  Sg T G ? S I NX
• S I NX an economys net exports must always
  equal the difference between its saving and its
  investment.
• NX trade balance tells us how our trade in
  goods/services departs from the benchmark of
  equal imports and exports
• Net capital outflow (S I) the difference
  between domestic saving and domestic investment

8
International Capital Flows and the Trade
Balance

• What does it mean if net capital outflow is
  positive/negative? Is the economy lending or
  borrowing?
• Net capital outflow equals the amount domestic
  residents are lending abroad minus the amount
  foreigners are lending to us. It reflects the
  international flow of funds to finance capital.

NX S I trade balance net capital outflow
S I NX gt 0 ? trade surplus are EX gt IM? Are
we borrowers/lenders? S I NX lt 0 ? trade
deficit are EX gt IM? Are we borrowers/lenders? S
I NX 0 ? balanced trade EX gt IM?
Borrowers/lenders/neither?
9
International Capital Flows and the Trade
Balance

• If our saving exceeds our investment, what
  happens to the saving that is not invested
  domestically? Why do foreigners require these
  loans? (trade surplus)
• If our investment exceeds saving, how is the
  extra investment in excess of our domestic saving
  financed? What do these foreign loans enable us
  to do? (trade deficit)

• International flow of capital can take many
  forms
• Foreign purchase of U.S. corporate or government
  bonds
• Foreign purchase of equity in a U.S. company

10
Saving and Investment in a Small Open Economy

• The next step is to develop an extension to the
  classical model that explains the variables that
  measure transactions in an open economy and the
  determinants of the international flow of
  goods/services and funds to finance capital
  accumulation.
• Many of this models features are carried over
  from Ch. 3

11
Capital Mobility and the World Interest Rate

• In the closed economy model, the real interest
  rate adjusts to equilibrate what? In the open
  economy model, we drop that assumption and allow
  countries to run a trade deficit (surplus) and
  borrow from (lend to) abroad.
• So what does determine the real interest rate?
  Consider the simplifying case of a small open
  economy with perfect capital mobility
• Small open economy a national economy that is a
  small part of the world market and thus can have
  only a negligible effect on the world interest
  rate (perfectly competitive firm)
• Perfect capital mobility a state where
  residents of a country have full and complete
  access to world financial markets and the
  government does not impede international
  borrowing/lending

12
Capital Mobility and the World Interest Rate

• The assumption of perfect capital mobility
  implies the the interest rate in our small open
  economy must equal the world interest rate r -
  the real interest rate prevailing in world
  financial markets ? r r Why?
• What happens when residents of a small open
  economy want to borrow (lend) and r gt r? Which
  real interest rate adjusts?
• If the real interest rate in our small open
  economy must equal the world real interest rate,
  what is it that determines the world real
  interest rate? Might it help to look at the
  world economy as one large closed economy?
• Because our open economy is small and because
  capital is perfectly mobile what kind of
  variable is r?

13
The Model

• Y Y F(K,L) C C(Y T) I I(r) r r
  
• NX (Y C G) I S I ?
  NX Y C(Y T) G
  I(r) S I(r)

Investment is still a downward-sloping
function of the interest rate,
As in Chapter 3,national saving does not depend
on the interest rate
but the exogenous world interest rate
determines the countrys level of investment.
r
I (r )
14
The Model

• NX S I(r)
• In a closed economy, the real interest rate
  adjusts to equilibrate saving and investment and
  is found where the saving and investment curves
  cross.
• In the small open economy, the real interest rate
  equals the world real interest rate.
• The trade balance is determined by the difference
  between saving and investment at the world
  interest rate.

15
How Policies Influence the Trade Balance
Three Experiments

• Fiscal policy at home
• Fiscal policy abroad
• An increase in investment demand

16
Fiscal Policy at Home

• Beginning in the position of balanced trade,
  consider the effects to the small open economy of
  a fiscal expansion (?G gt 0)
• What happens to national saving? Why?
• What happens to investment? Why?
• What happens to the trade balance? Why?
• What happens after a decrease in taxes (?T lt 0)?
  Again, what happens to saving, investment, and
  the trade balance?
• Starting from balanced trade, a change in fiscal
  policy that reduces national saving leads to a
  trade deficit.

17
NX and the Government Budget Deficit
18
Fiscal Policy Abroad

• Consider the effects to a small open economy when
  foreign governments increase spending
• What happens if the foreign country is small?
• What happens to world saving and the world real
  interest rate if the foreign country is large?
• What happens to investment in the small open
  economy? Why? What happens to saving? Why?
• What happens to the trade balance?
• Looking at the graph, why do the domestic saving
  and investment schedules not move?
• An increase in the world real interest rate due
  to a fiscal expansion abroad lead to a trade
  surplus.

19
Shifts in Investment Demand

• Consider the effects to a small open economy if
  investment opportunities suddenly became more
  profitable
• What happens to the investment schedule? Why?
• What happens to saving?
• How must the new investment be financed?
• What happens to net capital outflow?
• What happens to the trade balance?
• An outward shift in the investment schedule
  causes a trade deficit.

20
Case Study The U.S. Trade Deficit

• When have trade deficits been largest?
• Looking at national saving and domestic
  investment together, what do you think caused the
  trade deficits of the 1980s?
• According to our model, what policies would
  reduce national saving thereby causing a trade
  deficit?
• Why did national saving rise in the 1990s?
• With rising national saving, why did the trade
  balance continue to decline?

21
The nominal exchange rate
e nominal exchange rate, the relative price
of domestic currency in terms of foreign
currency (e.g. Yen per Dollar)
If the nominal exchange rate between the U.S.
dollar and the Japanese yen is 120 yen/dollar
then you can exchange one dollar for how many yen?
22
Exchange rates 6/6/2002 and 8/18/2003
23
The real exchange rate
real exchange rate, the relative price of
domestic goods in terms of foreign goods
(e.g. Japanese Big Macs per U.S. Big Mac)
e
The real exchange rate tells us the rate at which
we can trade the goods of one country for the
goods of another and is sometimes called the
terms of trade.
24
Understanding the units of e
e
25
McZample

• one good Big Mac
• price in Japan P 200 Yen
• price in USA P 2.50
• nominal exchange rate e 120 Yen/

To buy a U.S. Big Mac, someone from Japan would
have to pay an amount that could buy 1.5
Japanese Big Macs.
If the real exchange rate is high (low), foreign
goods are relatively cheap (expensive), and
domestic goods are relatively expensive (cheap).
26
e in the real world our model

• In the real worldWe can think of e as the
  relative price of a basket of domestic goods in
  terms of a basket of foreign goods.
• In our macro modelTheres just one good,
  output.So e is the relative price of one
  countrys output in terms of the other countrys
  output.

27
The Real Exchange Rate and the Trade Balance

• Does the real exchange rate exert any
  macroeconomic influence? (Think relative price)
• The relative price of domestic and foreign goods
  affects the demand for these goods.
• Suppose the real exchange rate is low which
  goods are relatively cheaper? So which goods
  will domestic residents tend to purchase? Which
  goods will foreign residents tend to purchase?
  What happens to the demand for our net exports?
• Suppose the real exchange rate is high answer
  the same questions as above
• The relationship between net exports and the real
  exchange rate can be represented as NX NX(e)

28
How NX depends on e

• ?e ? U.S. goods become more expensive relative
  to foreign goods
• ? ?EX, ?IM
• ? ?NX

In this small open economy model there is a
negative relationship between the trade balance
and the real exchange rate.
29
U.S. Net Exports and the Real Exchange Rate,
1975-2002
30
The NX curve for the U.S.
When e is relatively low, U.S. goods are
relatively inexpensive
e1
31
The NX curve for the U.S.
At high enough values of e, U.S. goods become so
expensive that
e2
32
The Determinants of the Real Exchange Rate

• In order to explain what determines the real
  exchange rate we combine the relationship between
  net exports and the real exchange rate just
  mentioned with the model of the trade balance
  developed earlier.
• We already know that the trade balance (NX) must
  equal net capital outflow, which in turn equals
  saving minus investment.
• How is saving determined?
• How is investment determined?
• How will net exports adjust to equal saving minus
  investment?
• e must adjust to ensure

33
How e is determined
Neither S nor I depend on e, so the net capital
outflow curve is vertical.
e 1
e adjusts to equate NX with net capital
outflow, S - I.
NX 1
34
Interpretation supply and demand in the foreign
exchange market
demand Foreigners need dollars to buy U.S. net
exports.
supply The net capital outflow (S - I ) is
the supply of dollars to be invested abroad.
e 1
NX 1
35
How Policies Influence the Real Exchange Rate

• Four Experiments
• Fiscal Policy at Home
• Fiscal Policy Abroad
• Shifts in Investment Demand
• Protectionist Trade Policies

36
Fiscal Policy at Home

• Consider the effects on the real exchange rate of
  an increase in government spending or a reduction
  in taxes.
• What happens to saving and thus net capital
  outflow? What then happens to the supply of
  dollars for foreign investment?
• What happens to the equilibrium real exchange
  rate?
• What happens to the relative price of domestic
  goods?
• What does this do to exports and imports?

37
Fiscal Policy Abroad

• Consider the effects on the real exchange rate of
  an increase in foreign government spending.
• What happens to world saving and the world real
  interest rate?
• What happens to domestic investment? What happens
  to net capital outflow?
• What happens to the supply of dollars to be
  invested abroad?
• What then happens to the equilibrium real
  exchange rate?
• What happens to the relative price of domestic
  goods and thus the demand for exports and
  imports?

38
Shifts in Investment Demand

• Consider the effects on the real exchange rate of
  an increase in investment demand.
• Because the real interest rate is fixed at the
  world level, what happens to investment?
• What happens to net capital outflow? Does this
  lead to higher trade deficits?
• What happens to the supply of dollars to be
  invested abroad? What happens to the real
  exchange rate?
• When the dollar appreciates, domestic goods
  become more expensive relative to foreign goods,
  and net exports fall.

39
The Effects of Trade Policies

• Consider the effects of a protectionist import
  reduction by the government.
• For any given real exchange rate, what happens to
  net exports? Why?
• What happens to saving and investment? What
  happens to the real exchange rate? Why?
• Do protectionist trade policies affect the trade
  balance according to our model? Why?
• Do protectionist trade policies alter the amount
  of trade? If so, how?
• Why do you think protectionist trade policies
  still exist?

40
The Determinants of the Nominal Exchange Rate

• Recall the relationship between the real and
  nominal exchange rate ? e ? (P/P) ? e ? ?
  (P/P)
• The nominal exchange rate depends on the real
  exchange rate and the price level in the two
  countries.

Given the value of ? if the domestic price level
rises what happens to e? Why? Given the value
of ? what happens to e if the foreign price level
rises? Why?
41
The Determinants of the Nominal Exchange Rate

• Consider the equation for the nominal exchange
  rate written in terms of growth rates

• This equation states that the change in the
  nominal exchange rate between the currencies of
  two countries equals the change in the real
  exchange rate plus the differences in their
  inflation rates.
• If a country has a high (low) rate of inflation
  relative to the U.S., a dollar will buy a(n)
  increasing (decreasing) amount of the foreign
  currency over time.
• Do we see the classical dichotomy at work again?
  
• Does this analysis suggest that monetary policy
  affects the nominal exchange rate? If so, how?

42
Inflation and the Nominal Exchange Rate
43
Chapter Summary

• Net exports--the difference between exports and
  imports or a countrys output (Y ) and its
  spending (C I G)
• Net capital outflow equals purchases of foreign
  assets minus foreign purchases of the countrys
  assets or the difference between saving and
  investment.
• National income accounts identities state that Y
  C I G NX and the trade balance NX S
  - I or net capital outflow.
• Impact of policies on NX
• NX increases if policy causes S to rise or I
  to fall
• NX does not change if policy affects neither S
  nor I. Example trade policy

44
Chapter Summary

• 5) Exchange rates
• nominal the price of a countrys currency in
  terms of another countrys currency
• real the price of a countrys goods in terms of
  another countrys goods
• The real exchange rate equals the nominal rate
  times the ratio of prices of the two countries.
• 6) How the real exchange rate is determined
• NX depends negatively on the real exchange rate,
  other things equal
• The real exchange rate adjusts to equate NX
  with net capital outflow
• 7) How the nominal exchange rate is determined
• e equals the real exchange rate times the
  countrys price level relative to the foreign
  price level.
• For a given value of the real exchange rate, the
  percentage change in the nominal exchange rate
  equals the difference between the foreign
  domestic inflation rates.