Intermediate Macroeconomics

CHAPTER 3. CLASSICAL THEORY:

OPEN ECONOMY IN THE
LONG RUN
Learning Objective

➢How Classical theory explains the performance of an open

economy in the long run.
Content
➢ Accounting identities for the open economy
➢ Relation between exchange rate and trade balance
➢ Small open economy in the long run
➢ Large open economy in the long run
The National Income Identity in an Open Economy

Y = C + I + G + NX

or, NX = Y – (C + I + G )

domestic
net exports spending

output
The National Income Identity in an Open Economy

NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
= S – I
The International Flows of Capital and Goods

➢The international flows of goods: NX = trade balance

➢The international flows of capital: S – I = net capital outflow
or net foreign investment
S – I = NFI = CO – CI
o CO: Domestic residents’ lending abroad
o CI: Foreigners’ lending to domestic country
o If S > I: Lending the excess to abroad: country is a net lender
o If S < I: Borrowing the shortage from abroad: country is a net
borrower
The International Flows of Capital and Goods

Since NX = S–I
Trade balance = Net foreign investment
The international flows of capital and the international flows of
goods are in balance.
➢A country with a trade deficit (NX < 0) is a net borrower (S < I ).
➢A country with a trade surplus (NX > 0) is a net lender (S > I ).
The Nominal Exchange Rate

e = nominal exchange rate,

the relative price of
domestic currency
in terms of foreign currency
(e.g. USD per VND)
The Real Exchange Rate

ε= real exchange rate,

the relative price of
domestic goods
in terms of foreign goods
(e.g. how many kg U.S. rice per 1 kg
Vietnamese rice)
Relation Between Nominal and Real Exchange Rate
one good: rice
price of 1 kg rice in the U.S.
P* = USD 1.2
price of 1 kg rice in Vietnam
P = VND 20,000
nominal exchange rate
e = 1/ 23,000 USD/VND
1 kg of rice in Vietnam
(1/ 23,000)  20,000
= 0.72 equals to 0.72 kg of rice in
1.2 the U.S.
e P
= 
P
The Real Exchange Rate and the Trade Balance

➢If the real exchange rate decreases, domestic goods become

relatively cheaper and thus exports increase and imports
decrease → Net exports increase.
➢If the real exchange rate increases, domestic goods become
relatively more expensive and thus exports decrease and
imports increase → Net exports decrease.
➢There is a negative relationship between the trade balance
and the real exchange rate.
NX = NX (ε)
THE SMALL OPEN ECONOMY MODEL
The assumptions:
➢ The economy’s output is fixed by the factors of production
and available technology.
𝑌ത = 𝐹(𝐾,
ഥ 𝐿ത )
➢ Consumption positively depends on disposable income.
𝐶 = 𝐶(𝑌ത − 𝑇)ത
➢ Investment negatively depends on the real interest rate.
𝐼 = 𝐼(𝑟)
➢ Government spending and taxes are exogenous
𝐺 = 𝐺ҧ and 𝑇 = 𝑇ത
➢ Small economy with free capital mobility
𝑟 = 𝑟∗
The Small Open Economy Model

➢The loanable funds market model

o How trade balance is determined and affected?
➢The foreign exchange market model
o How trade balance and exchange rate are determined and
affected?
The Small Open Economy Model: Loanable Funds
Market

➢The loanable funds market:

o Supply of loanable funds comes from national saving = S
o Demand for loanable funds comes from investment = I
The Supply of Loanable Funds

r S

National saving does not

depend on the interest rate

S = Y − C (Y − T ) − G

S, I
The Demand for Loanable Funds

Investment is a downward-sloping
function of the interest rate,

but the exogenous

r* world interest rate…
…determines the
country’s level of
I (r ) investment.

I (r* ) I
Loanable Funds Market
r 𝑺ത
The exogenous
world interest rate
determines
investment… NX
r*
…and the difference
between saving and
investment
determines net I
exports.
I (r*) S, I
Loanable Funds Market

➢The equilibrium of the loanable funds market is where

NX = S – I
Or 𝑁𝑋 = 𝑆ҧ − 𝐼(𝑟 ∗ )
➢The trade balance is determined by the difference between
saving and investment at the world interest rate.
The Effects of Policy on the Trade Balance

1. Fiscal policy at home

2. Fiscal policy abroad
3. An increase in investment
1. Fiscal Policy at Home
r
S2 S1
Expansionary fiscal
policy at home. NX2

r*
Results: NX1

• Investment is
unchanged.
• Net exports I
decrease.
I (r*) S, I
1. Fiscal Policy at Home

The loanable funds market is at initial equilibrium where:

NX1 = S1 – I(r*)
Event: The government conducts an expansionary fiscal policy: government
spending increases, tax decreases → Disposable income increases →
Consumption increases.
S↓ = Y – C ↑– G↑
→ National saving decreases → The supply of loanable funds curve shifts to
the left.
The loanable funds market reaches a new equilibrium where:
NX2 = S2 – I(r*)
NX2 < NX1 : Net exports decrease.
Conclusion: Expansionary fiscal policy leads to a decrease in net exports.
2. Fiscal Policy Abroad
r S1
Expansionary fiscal NX2
policy abroad raises
the world interest 𝑟2∗
rate. NX1
𝑟1∗

Results:
• Investment
level decreases. I
• Net exports
increase.
𝐼(𝑟2∗ ) 𝐼(𝑟1∗ ) S, I
3. An increase in Investment

r
S
A grant of NX2
investment tax r*
credits.

Results: NX1

• Investment I2
level increases.
• Net exports I1
decrease.
𝐼1 (𝑟 ∗) 𝐼2 (𝑟 ∗ ) S, I
The Small Open Economy Model: Foreign Exchange
Market
➢Foreign exchange market is the market for selling and buying
domestic currency in exchange to foreign currency.
o NX represents the net demand for domestic currency to buy
domestic goods. NX negatively depends on the real exchange
rate.
o S – I that represents net capital outflow or the supply of
domestic currency to be exchanged into foreign currency and
invested abroad. S – I does not depend on the real exchange
rate.
➢The real exchange rate is determined at the equilibrium of
the foreign exchange market

𝑁𝑋 𝜀 = 𝑆ҧ − 𝐼(𝑟 ∗ )
Foreign Exchange Market

S – I (r*)
ε
Real exchange rate is
determined at the
equilibrium of the
foreign exchange
market.
εE E

NX

S – I = NX S – I, NX
The Effects of Policy on the Real Exchange Rate

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment
4. Trade policy
1. Fiscal Policy at Home
𝑺𝟐 − 𝑰(𝒓∗ ) 𝑺𝟏 − 𝑰(𝒓∗ )
Expansionary fiscal ε
policy at home.

ε2 E2

E1
Results: ε1
• Real exchange
rate increases. NX
• Net exports
decrease. 𝑆2 − 𝐼 = 𝑁𝑋2 𝑆1 − 𝐼 = 𝑁𝑋1 S – I, NX
1. Fiscal Policy at Home
Initially the foreign exchange market is at equilibrium E1:
ε = ε1 ; NX1 = S1 – I
Event: The government conducts an expansionary fiscal policy: government
spending increases, tax decreases → Disposable income increases →
Consumption increases.
S↓ = Y – C↑ – G↑
National saving decreases → Supply of domestic currency curve shifts to the
left.
The foreign exchange market reaches the equilibrium at E2:
ε = ε2 ; NX2 = S2 – I
ε2 > ε1 : Real exchange rate increases
NX2 < NX1 : Net exports decrease
Conclusion: Expansionary fiscal policy leads to a higher real exchange rate and
lower net exports.
2. Fiscal Policy Abroad
𝑺 − 𝑰(𝒓∗𝟏 ) 𝑺 − 𝑰(𝒓∗𝟐 )
An increase in the
world interest rate
ε
r*.
ε1 E1

Results:
ε2 E2
• Real exchange
rate decreases.
• Net exports NX
increase.
S – I, NX
𝑆 − 𝐼 𝑟1∗ = 𝑁𝑋1 𝑆 − 𝐼 𝑟2∗ = 𝑁𝑋2
3. An increase in Investment

𝑺 − 𝑰𝟐 𝑺 − 𝑰𝟏
A grant of an ε
investment tax
credits.
ε2 E2

Results: ε1 E1
• Real exchange
rate increases. NX
• Net exports
decrease. S – I, NX
𝑆 − 𝐼2 = 𝑁𝑋2 𝑆 − 𝐼1 = 𝑁𝑋1
4. Trade Policy

Tariff imposed on 𝑺−𝑰

ε
imported goods.

ε2 E2

Results: E1
ε1
• Real exchange
𝑵𝑿𝟐
rate increases.
• Net exports are 𝑵𝑿𝟏
unchanged.
S – I, NX
𝑆 − 𝐼 = 𝑁𝑋
4. Trade Policy
Initially the foreign exchange market is at equilibrium E1:
ε = ε1 ; NX = S – I
Event: The government imposes tariff on imported goods → Import decreases
↑NX = X– M↓ → Net exports increase (1)
→ Demand for domestic currency curve shifts to the right.
The foreign exchange market reaches the equilibrium at E2:
ε = ε2 ; NX = S – I
ε2 > ε1 : Real exchange rate increases. Higher exchange rate makes domestic goods
become relatively more expensive compared to foreign goods → Export decreases
and import increases
↓NX = X ↓– M↑ → Net exports decrease (2)
Combine (1) and (2): Net exports are unchanged.
Conclusion: Tariff imposed on imported goods leads to a higher real exchange rate
and unchanged net exports.
The Determinants of the Nominal Exchange Rate

Start with the expression for the real exchange rate:

e P
ε =
P*
Solve it for the nominal exchange rate:
P*
e = ε 
P
The Determinants of the Nominal Exchange Rate

P*
e = ε 
P
We can rewrite this equation in terms of growth rates

e ε P * P ε
= + − = + * − 
e ε P *
P ε

For a given value of ε, the growth rate of e equals the difference

between foreign and domestic inflation rates.
THE LARGE OPEN ECONOMY MODEL
The assumptions:
➢ The economy’s output is fixed by the factors of production
and available technology.
𝑌ത = 𝐹(𝐾,
ഥ 𝐿ത )
➢ Consumption positively depends on disposable income.
𝐶 = 𝐶(𝑌ത − 𝑇)ത
➢ Investment negatively depends on the real interest rate.
𝐼 = 𝐼(𝑟)
➢ Government spending and taxes are exogenous
𝐺 = 𝐺ҧ and 𝑇 = 𝑇ത
➢ Large economy with free capital mobility
𝑟 ≠ 𝑟∗
The Large Open Economy Model

➢Net capital outflow:

NFI = NFI(r) = CO – CI
o If the real domestic interest rate is higher, foreigners want to
lend more to the domestic country CI↑ causing NFI to decrease.
o If the real domestic interest rate is lower, domestic residents
want to lend more overseas CO↑ causing NFI to rise.
➢Net capital outflow depends negatively on the real domestic
interest rate.
o If NFI > 0: Lend abroad (net lender)
o If NFI < 0: Borrow from abroad (net borrower)
The Large Open Economy Model

➢Consider 2 key markets:

o The loanable funds market: where the real interest rate is
determined.
o The foreign exchange market: where the real exchange rate is
determined.
The Large Open Economy Model

➢The loanable funds market

o Supply of loanable funds come from domestic saving: S.
o Demand for loanable funds come from domestic investment
and net foreign investment: I + NFI
➢At the equilibrium
S = I + NFI
𝑆ҧ = 𝐼 𝑟 + 𝑁𝐹𝐼(𝑟)

The market equilibrium determines the real exchange rate.

The Loanable Funds Market

S
Real interest
r
rate is
determined at
the equilibrium
of the loanable
funds market.
rE E

I + NFI

S, I + NFI
S = I + NFI
The Large Open Economy Model

➢The foreign exchange market:

o NX represents the demand for domestic currency.
o NFI represents the supply of domestic currency.
➢At the equilibrium
NX = NFI
NX(ε) = NFI
The market equilibrium determines the real exchange rate.
The Foreign Exchange Market

ε NFI
Real exchange
rate is
determined at
the equilibrium
of the foreign
exchange
εE E
market.

NX

NFI, NX
NFI = NX
The Large Open Economy Model

➢The open economy is in equilibrium when there is a simultaneous

equilibrium in the two markets.
o Equilibrium in the loanable funds market
S = I + NFI
o Equilibrium in the foreign exchange market
NX = NFI
➢Equilibrium in the open economy will determine basic
macroeconomic variables
o Net exports
o Net foreign investment
o Real interest rate
o Real exchange rate
 r S r

𝑟𝐸 E

I + NFI NFI

S, I + NFI NFI
S = I + NFI
𝜀 NFI
Loanable funds market

𝜀𝐸 E

NX

NFI = NX NX, NFI

Foreign exchange market

Policies in the Large Open Economy

1. Fiscal policy
2. Investment policy
3. Trade policy
 1. Expansionary Fiscal Policy
r 𝑆2 𝑆1 r

𝑟2 𝐸2
𝑟1 𝐸1

I + NFI NFI

𝑆2 = (𝐼 + 𝑁𝐹𝐼)2 𝑆1 = (𝐼 + 𝑁𝐹𝐼)1 S, I + NFI NFI

𝜀 𝑁𝐹𝐼2 𝑁𝐹𝐼1
Loanable funds market

𝜀2 𝐸2
𝜀1 𝐸1

NX

𝑁𝐹𝐼2 = 𝑁𝑋2 𝑁𝐹𝐼1 = 𝑁𝑋1 NX, NFI

Foreign exchange market

Expansionary Fiscal Policy
The economy is initially at equilibrium E1 : r = r1; ɛ = ɛ1

Event: The government conducts expansionary fiscal policy: government spending increases, tax
decreases → Disposable income increases → Consumption increases.

↓S = Y – C↑ – G↑ National saving decreases

In the loanable funds market: Decrease in national saving makes the supply of loanable funds
curve shift to the left. The new established equilibrium E2 determines the real interest rate r2 .
r2 > r1 : real interest rate rises. Higher real interest rate causes net foreign investment to fall.

In the foreign exchange market: Decrease in net foreign investment makes the supply of domestic
currency curve shift to the left. The new established equilibrium E2 determines the real exchange
rate ɛ2 .
ɛ2 > ɛ1 : real exchange rate increases. A higher real exchange rate makes domestic goods
become relatively more expensive compared to foreign goods which leads to lower exports and
higher imports → net exports decrease.

Conclusion: Expansionary fiscal policy leads to a higher real interest rate, a higher real exchange
rate, lower net foreign investment and lower net exports.
 2. Investment Attraction Policy
r 𝑆 r

𝑟2 𝐸2

𝑟1
𝐸1
𝐼2 + 𝑁𝐹𝐼
NFI
𝐼1 + 𝑁𝐹𝐼
S, I + NFI NFI
𝑆 = 𝐼 + 𝑁𝐹𝐼
𝜀 𝑁𝐹𝐼2 𝑁𝐹𝐼1
Loanable funds market

Investment attraction policy. 𝜀2 𝐸2

Results: 𝐸1
• Real interest rate increases. 𝜀1
• Real exchange rate increases.
• Net foreign investment decreases.
• Net exports decrease. NX

𝑁𝐹𝐼2 = 𝑁𝑋2 𝑁𝐹𝐼1 = 𝑁𝑋1 NX, NFI

Foreign exchange market
 r
3. Trade Policy
S r

𝑟1 𝐸1

I + NFI NFI

S, I + NFI NFI
S = I + NFI
𝜀 NFI
Loanable funds market
𝐸2
𝜀2
Tariff imposed on imported goods.
Results: 𝜀1 𝐸1
• Real interest rate is unchanged.
𝑁𝑋2
• Real exchange rate increases.
• Net foreign investment is 𝑁𝑋1
unchanged.
• Net exports are unchanged.
NFI = NX NX, NFI

Foreign exchange market

Trade Policy
The economy is initially at equilibrium E1 : r = r1; ɛ = ɛ1
Event: The government imposes tariff on foreign imported goods → Import decreases.
↑NX = X – M↓
Net exports increase (1)
In the foreign exchange market: Increase in net exports makes the demand for domestic currency
curve shift to the right. The new established equilibrium E2 determines the real exchange rate ɛ2 .
ɛ2 > ɛ1 : real exchange rate increases. A higher real exchange rate makes domestic goods
become relatively more expensive compared to foreign goods which leads to lower exports and
higher imports.
↓NX = X↓ – M↑
Net exports decrease (2)
Combine (1) and (2): Net exports are unchanged.
At equilibrium of foreign exchange market, NX = NFI. Since net exports are unchanged then net
foreign investment is unchanged.
The loanable funds market is not affected then real interest rate is unchanged.
Conclusion: Tariff imposed on foreign imported goods leads to a higher real interest rate,
unchanged real exchange rate, unchanged net foreign investment and unchanged net exports.