The Open Economy

Chapter Five

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.

Imports and Exports

as a percentage of output: 2000

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?

The Role of Net Exports

superscripts:
C C C
d =spending on
d
f
domestic
I I I
goods
d
f
G G G
f = spending on
foreign goods
Y = (C Cf) + (I If) + (G Gf) + EX
d

Y = C + I + G + EX (Cf + If + Gf)
IM = imports = Cf + If + Gf
Y = C + I + G + EX - IM

 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 )

domestic
spending

net
exports
output

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

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

 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
NX
S

I
NX capital.
=SI
flow of funds to finance
trade
tradebalance
balance==net
netcapital
capital
outflow
outflow
S I = NX > 0 trade surplus; are EX > IM? Are we
borrowers/lenders?
S I = NX < 0 trade deficit; are EX > IM? Are we
borrowers/lenders?

 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:
1) Foreign purchase of
U.S. corporate or
government bonds
2) Foreign purchase of
equity in a U.S.

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:
production
function: Y Y F (K , L)

consumption function:

C C (Y T )

investment function:

I I (r )

exogenous policy variables: G G , T T

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

 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 > 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*?

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*)

As in
Chapter 3,
national
saving
r
does not
depend on *
the interest
rate

S
,I

Investment is still a
downward-sloping
function
of the but
interest
rate,
the exogenous
world interest
rate

determines
the
countrys
I(r)
level of
investment
I (r* )

. S

 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.

How Policies Influence the Trade

Balance
Three Experiments

1) Fiscal policy at home

2) Fiscal policy abroad
3) An increase in investment
demand

Fiscal Policy at Home

Beginning in the position of
balanced trade, consider the
effects to the small open
economy of a fiscal
expansion (G > 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 < 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.

NX and the Government Budget

Deficit
Budget deficit
(right scale)

Net exports
(left scale)

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.

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.

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?

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?

Exchange rates: 6/6/2002 and

8/18/2003
country

exchange rate
6/6/02

exchange rate
8/18/03

Euro

1.06 Euro/$

0.8976 Euro/$

Japan

124.3 Yen/$

119.4 Yen/$

Mexico

9.7 Pesos/$

10.73 Pesos/$

Russia

31.4 Rubles/$

30.4 Rubles/$

South
Africa

9.8 Rand/$

7.28 Rand/$

Turkey

1,444,063.1 Liras/
$

1,404,436.2 Liras/
$

U.K.

0.68 Pounds/$

0.63 Pounds/$

The real exchange rate

=
the
lowercase
Greek letter
epsilon

real exchange rate,

the relative price of
domestic goods
in terms of foreign goods
(e.g. Japanese Big Macs per
U.S. Big Mac)

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.

Understanding the units of

e P
P*

(Yen per $) ($ per unit U.S. goods)

Yen per unit J apanese goods

Yen per unit U.S. goods

Yen per unit J apanese goods

Units of J apanese goods

per unit of U.S. goods

~ McZample
~
one good: Big Mac
price in Japan:
P* = 200 Yen
price in USA:
P = $2.50
nominal exchange
rate
e = 120 Yen/$

To
Tobuy
buyaaU.S.
U.S.Big
BigMac,
Mac,
someone
someonefrom
fromJapan
Japan
would
wouldhave
haveto
topay
payan
an
amount
amountthat
thatcould
couldbuy
buy
1.5
1.5Japanese
JapaneseBig
BigMacs
Macs..

e P

P*
120 $2.50

1.5 If the real exchange rate is high

200 Yen
(low), foreign goods are relatively
cheap (expensive), and domestic
goods are relatively expensive
(cheap).

 in the real world & our model

In the real world:
We can think of as the relative price of
a basket of domestic goods in terms of a
basket of foreign goods.
In our macro model:
Theres just one good, output.
So is the relative price of one countrys
output in terms of the other countrys
output.

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()

How NX depends on

U.S. goods become more
expensive relative to foreign goods

EX, IM

NX

In this
this small
small open
open economy
economy model
model there
there is
is aa
In
negative relationship
relationship between
between the
the trade
trade
negative
balance and
and the
the real
real exchange
exchange rate.
rate.
balance

140

120

100

-1

80

-2

60

-3

40

-4

20

-5

1975

1980

1985

1990

1995

Net exports (left scale)

Real exchange rate (right scale)

2000

1998:2 = 100

Percent of GDP

U.S. Net Exports and the

Real Exchange Rate, 1975-2002

The NX curve for the U.S.

so U.S. net
exports will
be high
When is
relatively low,
U.S. goods are
relatively
inexpensive

NX(1)

NX(
)
N
X

The NX curve for the U.S.

At high enough
values of ,
U.S. goods
become so
expensive that
we export less
than we
import

NX(
)
NX(2)

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?

( to)ensure:
S I
must NX
adjust

r( * )

How is determined
Neither S nor I
depend on ,
so the net
capital outflow
curve is
vertical.
adjusts to
equate NX
with net capital
outflow, S I.

S1 I (r *)

NX 1

NX(
)
NX

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.

S1 I (r *)

NX 1

NX(
) NX

How Policies Influence the Real Exchange

Rate
Four Experiments
1) Fiscal Policy at Home
2) Fiscal Policy Abroad
3) Shifts in Investment Demand
4) Protectionist Trade Policies

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?

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?

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.

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?

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

 The Determinants of the Nominal

Exchange Rate
Consider the equation for the nominal exchange rate
written in terms of growth rates:

e P P*

*
e
P
P

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

Inflation and the Nominal Exchange

Rate

Chapter Summary
Net exports--the difference between exports and
imports or a countrys output (Y ) and its spending (C +
I + G)
2.
Net capital outflow equals purchases of foreign assets
minus foreign purchases of the countrys assets or the
difference between saving and investment.
3.
National income accounts identities state that Y = C +
I + G + NX and the trade balance NX = S I or net
capital outflow.
4.
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
1.

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.