CHAPTER 3.

CLASSICAL
THEORY: THE OPEN ECONOMY
IN THE LONG RUN
OVERVIEW
 In Topic 2 we study the Classical theory for the closed
economy in the long run.
 Now we continue with the Classical theory for the open
economy in the long run.
 Accounting identities for the open economy
 How the trade balance and exchange rate are determined?
 How policies affect trade balance and exchange rate?
THE NATIONAL INCOME IDENTITY IN AN
OPEN ECONOMY

Y = C + I + G + NX

or, NX = Y – (C + I + G )

domestic
net exports spending

output
INTERNATIONAL CAPITAL FLOWS

NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
= S – I
THE INTERNATIONAL FLOWS OF
CAPITAL AND GOODS
 S – I is called net capital outflow or net foreign investment
S – I = NFI = CO – CI
 CO: Domestic residents’ lending abroad
 CI: Foreigners’ lending to domestic country
 If S > I: Lending the excess to abroad: country is a net lender
 If S < I: Borrowing the shortage from abroad: country is a net
borrower
THE NATIONAL INCOME IDENTITY IN AN
OPEN ECONOMY

 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)
THE 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 / 23,000)  20,000
 0.72 1 kg of rice in Vietnam
1.2 equals to 0.72 kg of rice in
e P the U.S.
 
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.
Y  F ( K , L)  Y
 Consumption positively depends on disposable income.
C  C Y  T 
 Investment negatively depends on the real interest rate.
I = I(r)
 Government spending and taxes are exogenous
GG T T
 Small economy with free capital mobility
r = r*
THE SMALL OPEN ECONOMY MODEL:
LOANABLE FUNDS MARKET
 The loanable funds market:
 Supply
of loanable funds comes from national saving.
 Demand for loanable funds comes from investment.
THE SUPPLY OF LOANABLE FUNDS

r S  Y  C (Y  T )  G

National saving does not

depend on the interest rate

S 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
THE SMALL OPEN ECONOMY MODEL: LOANABLE
FUNDS MARKET

r 𝑺
The exogenous
world interest rate
determines
investment… NX
r*
…and the
difference between
saving and
investment I
determines net
exports. I(r*) S, I
THE SMALL OPEN ECONOMY MODEL:
LOANABLE FUNDS MARKET
 The equilibrium of the loanable funds market is where
NX = S – I
or

NX  S  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 demand

1. FISCAL POLICY AT HOME
r S 2 S1
Expansionary
fiscal policy at NX2
home. 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 or tax decreases)
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 𝑟∗
2
rate. NX1
𝑟∗
1

Results:
• Investment
level decreases. I
• Net exports
increase.
¿ ¿ S, I
3. AN INCREASE IN INVESTMENT DEMAND
r
S
A grant of NX2
investment tax r*
credits.

Results: NX1

• Investment I2
level increases.
• Net exports I1
decrease.

¿ ¿ 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.
 NX represents the net demand for domestic currency to buy
domestic goods. NX negatively depends on the real exchange rate.
 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 )  S  I (r *)
THE SMALL OPEN ECONOMY MODEL: 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 demand

4. Trade policy
1. FISCAL POLICY AT HOME
¿ ¿
Expansionary ε
fiscal policy at
home. E2
ε2

E1
Results: ε1
• Real exchange
rate increases. NX
• Net exports
decrease. 𝑆 2 − 𝐼 = 𝑁𝑋𝑆21 − 𝐼 = 𝑁𝑋 1S – 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 or tax decreases)
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

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 ( 𝑟 1 )= 𝑁𝑋 1𝑆 − 𝐼 ( 𝑟 ∗
∗
2 )= 𝑁𝑋 2
3. AN INCREASE IN INVESTMENT DEMAND

𝑺 − 𝑰𝟐𝑺 − 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 − 𝐼 2= 𝑁𝑋 2𝑆 − 𝐼 1= 𝑁𝑋 1
4. TRADE POLICY

Tariff imposed on
ε 𝑺−𝑰
imported goods.

ε2 E2

Results: ε1 E1
• Real exchange
rate increases.
𝑵𝑿 𝟐
• Net exports are
unchanged.
𝑵𝑿 𝟏
S – I, NX
𝑆 − 𝐼 =𝑁𝑋
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.
Y  F ( K , L)  Y
 Consumption positively depends on disposable income.
C  C Y  T 
 Investment negatively depends on the real interest rate.
I = I(r)
 Government spending and taxes are exogenous
GG T T
 Large economy with free capital mobility
r  r*
THE LARGE OPEN ECONOMY MODEL
 Net capital outflow:
NFI = NFI(r) = CO – CI
 If the real domestic interest rate is higher, foreigners want to
lend more to the domestic country CI↑ causing NFI to
decrease.
 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.
 If NFI > 0: Lend abroad (net lender)

 If NFI < 0: Borrow from abroad (net borrower)

THE LARGE OPEN ECONOMY MODEL
 Consider 2 key markets:
 The loanable funds market: where the real interest rate is
determined.
 The foreign exchange market: where the real exchange rate
is determined.
THE LARGE OPEN ECONOMY MODEL
 The loanable funds market
 Supply of loanable funds come from domestic saving: S.
 Demand for loanable funds come from domestic
investment and net foreign investment: I + NFI
 At the equilibrium
S = I + NFI

S  I (r )  NFI (r )
 The market equilibrium determines the real exchange
rate.
THE LOANABLE FUNDS MARKET

S
r
Real interest
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:
 NX represents the demand for domestic currency.
 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
market.

εE E

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.
 Equilibrium in the loanable funds market
S = I + NFI
 Equilibrium in the foreign exchange market

NX = NFI
 Equilibrium in the open economy will determine basic
macroeconomic variables
 Net exports
 Net foreign investment
 Real interest rate
 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 𝑆 2 𝑆1 r

𝑟2 𝐸2
𝑟1 𝐸1

I + NFI NFI

S, I + NFI NFI
Loanable funds market 𝜀 𝑁𝐹𝐼 2 𝑁𝐹𝐼 1

𝜀2 𝐸2
𝜀1 𝐸1

NX

𝑁𝐹𝐼
𝑁𝐹𝐼 2=𝑁𝑋 2 1=𝑁𝑋 1 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 (G increases or T decreases).
↓S = Y – C↑  – G↑ 
 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 will
make 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
𝐼 2+ 𝑁𝐹𝐼
NFI
𝐼 1 + 𝑁𝐹𝐼
S, I + NFI NFI
Loanable funds market
𝜀 𝑁𝐹𝐼 2 𝑁𝐹𝐼 1
Investment attraction policy.
Results: 𝜀2 𝐸2
• Real interest rate increases.
𝜀1 𝐸1
• Real exchange rate increases.
• Net foreign investment
decreases.
• Net exports decrease. NX

𝑁𝐹𝐼
𝑁𝐹𝐼 2=𝑁𝑋 2 1=𝑁𝑋 1 NX, NFI
Foreign exchange market
 3. TRADE POLICY
r S r

𝑟1 𝐸1

I + NFI NFI

S, I + NFI NFI
Loanable funds market 𝜀 NFI

Tariff imposed on imported goods. 𝐸2

Results: 𝜀2
• Real interest rate is unchanged.
• Real exchange rate increases. 𝜀1 𝐸1
• Net foreign investment is 𝑁𝑋 2
unchanged.
• Net exports are unchanged. 𝑁𝑋 1

NFI = NX NX, NFI

Foreign exchange market