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 spending
exports
output
INTERNATIONAL CAPITAL FLOWS

NX
NX ==YY –– (C
(C ++II +
+G G))
implies
implies
NX
NX == (Y
(Y ––CC ––G
G))–– II
== SS –– II
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
11kg
kgofofrice
ricein
inVietnam
Vietnam
equals
equalsto to0.72
0.72kgkgof
of
e P rice
ricein
inthe
theU.S.
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 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 SUPPLY OF LOANABLE FUNDS

r S Y  C (Y  T )  G

National saving does

not depend on the
interest rate

S S, 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 NX2
fiscal policy
abroad raises 𝑟∗
2
the world NX1
∗
interest rate. 𝑟1

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

Results: NX1

• Investment I2
level increases
. I1
• Net exports
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*)
Real exchange rate
ε
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 NX
rate
increases. 𝑆 2 − 𝐼 = 𝑁𝑋
𝑆 12− 𝐼 = 𝑁𝑋 S1 – I,
• Net exports NX
decrease.
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 ε
interest rate r*.
ε1 E1

Results:
ε2 E2
• Real exchange
rate
decreases. NX
• Net exports
increase. S – I,
𝑆 − 𝐼 (𝑟 ∗
1 ) = 𝑁𝑋𝑆
1 − 𝐼 ( 𝑟 2 ) = 𝑁𝑋 2
∗
NX
4. TRADE POLICY

Tariff imposed
ε 𝑺− 𝑰
on imported
goods.
ε2 E2

Results: ε1 E1
• Real exchange
rate
𝑵𝑿 𝟐
increases.
• Net exports
𝑵𝑿 𝟏
are S – I,
unchanged. 𝑆 − 𝐼 =𝑁𝑋 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
3. AN INCREASE IN INVESTMENT DEMAND

𝑺 − 𝑰 𝟐𝑺 − 𝑰 𝟏
A grant of an ε
investment tax
credits.
ε2 E2

Results: ε1 E1
• Real
exchange NX
rate
increases. S – I,
• Net exports
𝑆 − 𝐼 2 =𝑁𝑋𝑆
2 − 𝐼 1 =𝑁𝑋 1 NX

decrease.
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
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:
 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 𝑆2
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
𝜀1 𝐸1
increases.
• Real exchange rate
increases.
• Net foreign investment NX
decreases.
• Net exports decrease. 𝑁𝐹𝐼
𝑁𝐹𝐼 2=𝑁𝑋 =𝑁𝑋 1
2 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 𝐸2

goods. 𝜀2
Results:
• Real interest rate is 𝜀1 𝐸1
unchanged. 𝑁𝑋 2
• Real exchange rate
increases. 𝑁𝑋 1
• Net foreign investment is
unchanged.
NFI = NX NX, NFI
• Net exports are
unchanged. Foreign exchange market