In this chapter, you will learn:
accounting identities for the open economy
the small open economy model
what makes it “small”
how the trade balance and exchange rate
are determined
how policies affect trade balance &
exchange rate
In an open economy,
Last chapters we study only closed economy.
But in real world all economies are integrated.
All countries are exporting, importing, lending
and bowering. Y=C+I+G+NX(Exports-imports)
6.1. The International Flows of Capital and
Goods;
Difference b/w closed and open economy is;
spending need not equal output
saving need not equal investment
Role of Net Export
superscripts:
C C d C f d = spending on
d f domestic goods
I I I f = spending on
G G d G f foreign goods
EX = exports =
foreign spending on domestic goods
IM = imports = C f + I f + G f
= spending on foreign goods
NX = net exports (a.k.a. the “trade balance”)
= EX – IM
GDP = expenditure on
domestically produced g & s
Y C d I d
G d EX
ff f
(C C ) (I I ) (G G ) EX
C I G EX (C ff I Gf )
C I G EX I M
C I G NX
The national income identity
in an open economy
Y = C + I + G + NX
or, NX = Y – (C + I + G )
domestic
spending
net exports
output
Trade surpluses and deficits
NX = EX – IM = Y – (C + I + G )
trade surplus:
output > domestic spending and exports >
imports
trade surplus & Positive NX
trade deficit:
spending > output and imports > exports
trade deficit & negative NX
International capital flows
The link between trade & cap. flows
NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
= S – I
trade balance = net capital outflow
Thus,
Thus,
aa country
country with
with aa trade
trade deficit
deficit (NX
(NX << 0)
0)
is
is aa net
net borrower
borrower (S (S <<II ).).
Saving and investment in a
small open economy
An open-economy version of the loanable
funds model from Chapter 3.
Includes many of the same elements:
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
National saving:
The supply of loanable funds
r S Y C (Y T ) G
As
As inin Chapter
Chapter 3,3,
national
national saving
saving does
does
not
not depend
depend onon the
the
interest
interest rate
rate
S S, I
Assumptions about capital flows
a. domestic & foreign bonds are perfect substitutes
(same risk, maturity, etc.)
b. perfect capital mobility:
no restrictions on international trade in assets
c. economy is small:
cannot affect the world interest rate, denoted r*
a,b&c
a,b&c imply
imply rr == r*
r*
r*
r* is
is World
World interest
interest rate
rate
Investment:
The demand for loanable funds
r Investment is still a
downward-sloping function
of the interest rate,
but the exogenous
world interest rate…
r*
…determines the
country’s level of
investment.
I (r )
I (r* ) S, I
If the economy were closed…
r S
…the
…the interest
interest
rate
rate would
would
adjust
adjust to
to
equate
equate
investment
investment
and
and saving:
saving: rc
I (r )
I (rc ) S, I
S
But in a small open economy…
r
the
the exogenous
exogenous S
world
world interest
interest
rate
rate determines
determines
investment… NX
investment…
r*
…and
…and thethe
difference
difference rc
between
between saving
saving
and
and investment
investment
I (r )
determines
determines netnet
capital
capital outflow
outflow I1 S, I
and
and net
net exports
exports
Next, three experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
(exercise)
1. Fiscal policy at home
r
S 2 S1
An
An increase
increase in
in GG
or
or decrease
decrease inin TT NX2
reduces
reduces saving.
saving. r*
1
Results: NX1
I 0
NX S 0
I (r )
NX ,Tradedeficit
I1 S, I
2. Fiscal policy abroad
r
Expansionary S1
NX2
fiscal policy
abroad raises r2*
NX
the world *
interest rate. r1
1
Results:
Results:
I 0 I (r )
NX I 0
NX ,TradeSurpluse S, I
*
I (r )
2
I (r1* )
NOW YOU TRY:
3. An increase in investment demand
r
Use the S
model to
determine r*
the impact of
an increase
NX
in investment
1
demand on
NX, S, I, and I (r )1
net capital I1 S, I
outflow.
ANSWERS:
3. An increase in investment
demand r
S
I >
I > 0,
0, NX
S =
S = 0,
0, r* 2
net
net capital
capital
outflow
outflow and
and
NX
NX fall
fall NX
by
by the
the 1 I (r )2
amount I
amount I
I (r )1
I1 I2 S, I
The nominal exchange rate
e = nominal exchange rate,
the relative price of
domestic currency
in terms of foreign currency
(e.g. Yen per Dollar)
The real exchange rate
ε = real exchange rate,
the relative price of
the domestic goods
lowercase in terms of foreign goods
Greek letter
epsilon
(e.g. Japanese car per U.S. car
ε= e* Price of domestic
good/price of foreign
good
~ 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,
e P someone
someonefrom
fromJapan
Japan
ε would
P* wouldhave
haveto topay
payan
an
120 $2.50 amount
amountthat
thatcould
couldbuy
buy
1.5 1.5
200 Yen 1.5Japanese
JapaneseBigBigMacs.
Macs.
ε in the real world & our model
In the real world:
We can think of ε as the relative price of
a basket of domestic goods in terms of a basket
of foreign goods.
When real exchange rate is high, its means
foreign good are cheap and domestic goods
are expensive.
How NX depends on ε
ε Pakistani goods become more expensive
relative to foreign goods
EX, IM
NX
The net exports function
The net exports function reflects this inverse
relationship between NX and ε :
NX = NX(ε )
The NX curve for the Pakistan.
so Pakistan.
When ε is net exports
relatively low, will
Pakistan goods be high
are relatively ε1
inexpensive
NX
0 ( ε)
NX(ε1) N
X
The NX curve for the U.S.
ε At high enough
values of ε,
ε2 Pakistani goods
become so
expensive that
we export
less than
we import
NX
0 ( ε)
NX(ε2) N
X
How ε is determined
The accounting identity says NX = S – I
We saw earlier how S – I is determined:
S depends on domestic factors (output, fiscal
policy variables, etc)
I is determined by the world interest
rate r *
So, ε must adjust to ensure
NX (ε ) S I (r * )
How ε is determined
Neither S
Neither nor II
S nor S1 I (r *)
ε
depend
depend on on ε,
ε,
so
so the
the net
net capital
capital
outflow
outflow curve
curve is
is
vertical.
vertical.
ε1
εε adjusts
adjusts to
to
equate
equate NXNX NX(ε
with
with net
net capital
capital )
NX
outflow, S
outflow, S I.I. NX 1
Interpretation: supply and demand
in the foreign exchange market
demand:
demand: S1 I (r *)
ε
Foreigners
Foreigners need
need
dollars
dollars to
to buy
buy
U.S.
U.S. net
net exports.
exports.
supply:
supply: ε1
Net
Net capital
capital
outflow
outflow (S(S II)) NX(ε
is )
is the
the supply
supply of of NX
dollars
dollars to
to be
be NX 1
invested
invested abroad.
abroad.
Next, four experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
(exercise)
4. Trade policy to restrict imports
1. Fiscal policy at home
A S 2 I (r *)
A fiscal
fiscal expansion
expansion
reduces
reduces national
national ε S1 I (r *)
saving,
saving, netnet capital
capital
outflow,
outflow, and
and the
the ε2
supply
supply of of dollars
dollars
in
in the
the foreign
foreign
exchange ε1
exchange
market…
market… NX(ε
…causing )
…causing the
the real
real NX
exchange
exchange rate
rate to
to NX 2 NX 1
rise
rise and
and NX
NX to
to fall.
fall.
2. Fiscal policy abroad
An
An increase
increase in in r*
r* S1 I (r1*)
reduces
reduces ε S1 I (r2* )
investment,
investment,
increasing
increasing net net
capital ε1
capital outflow
outflow
and
and the
the supply
supply ofof
dollars
dollars in
in the
the ε2
foreign
foreign exchange
exchange
market…
market… NX(ε
)
…causing NX
…causing the
the real
real NX 1 NX 2
exchange
exchange rate
rate to
to fall
fall
and
and NX
NX to
to rise.
rise.
NOW YOU TRY:
3. Increase in investment demand
Determine
Determine thethe ε S1 I 1
impact
impact of
of an
an
increase
increase in
in
investment
investment
demand
demand on on
net
net exports,
exports, ε1
net
net capital
capital
NX(ε
outflow,
outflow, )
and
and the
the real
real NX
exchange NX 1
exchange rate
rate
ANSWERS:
3. Increase in investment demand
An S1 I 2
An increase
increase in in
investment
investment ε S1 I 1
reduces
reduces net
net
capital
capital outflow
outflow ε2
and
and the
the supply
supply
of
of dollars
dollars in
in the
the
foreign
foreign ε1
exchange
exchange
market…
market… NX(ε
)
…causing
…causing the
the real
real NX
NX 2 NX 1
exchange
exchange rate
rate to to rise
rise
and
and NX
NX to
to fall.
fall.
4. Trade policy to restrict imports
At
At any
any given
given value
value of
of
ε S I
ε,
ε, an
an import
import quota
quota
IM
IM NX
NX
demand
demand for for ε2
dollars
dollars shifts
shifts
right
right ε1
NX (ε )2
Trade
Trade policy
policy doesn’t
doesn’t NX (ε )1
affect or II ,, so
affect SS or so
capital
capital flows
flows and and the
the NX
NX1
supply
supply ofof dollars
dollars
remain
remain fixed.
fixed.
4. Trade policy to restrict imports
Results:
Results:
ε S I
ε
ε >> 00
(demand
(demand
increase)
increase) ε2
NX
NX == 00
(supply
(supply fixed)
fixed) ε1
IM
IM << 00 NX (ε )2
(policy)
(policy) NX (ε )1
EX
EX << 00
NX
(rise in εε ))
(rise in NX1
The determinants of the
nominal exchange rate
Start with the expression for the real exchange
rate: e P
ε
P*
Solve for the nominal exchange rate:
P*
e ε
P
The determinants of the
nominal exchange rate
So e depends on the real exchange rate and
the price levels at home and abroad…
…and we know how each
of them is determined:
P*
e ε
P
The determinants of the
nominal exchange rate
If P will increase it will ↑e and rupees buy less
foreign currency( depreciates). If ↑ than
rupees by more currency (appreciates).
P*
e ε
P
The determinants of the
nominal exchange rate
P*
e ε
P
Rewrite this equation in growth rates
(see “arithmetic tricks for working with percentage
changes,” Chap 2 ):
e ε P * P ε *
*
e ε P P ε
Purchasing Power Parity (PPP)
Two definitions:
A doctrine that states that goods must sell at the
same (currency-adjusted) price in all countries.
The nominal exchange rate adjusts to equalize
the cost of a basket of goods across countries.
Reasoning:
arbitrage, the law of one price
Purchasing Power Parity (PPP)
PPP: e P = P* Cost of a basket of
foreign goods, in
foreign currency.
Cost of a basket of Cost of a basket of
domestic goods, in domestic goods, in
foreign currency. domestic currency.
Solve for e : e = P*/ P
PPP implies that the nominal exchange rate
between two countries equals the ratio of the
countries’ price levels.
Purchasing Power Parity (PPP)
If e = P*/P, *
P P P
thenε e * * 1
P P P
and the NX curve is horizontal:
ε
S I Under
Under PPP, PPP,
changes
changes in in
(S –– II )) have
(S have no
no
ε =1 NX impact
impact on on εε or
or e.
e.
NX
Does PPP hold in the real world?
No, for two reasons:
1. International arbitrage not possible.
nontraded goods
transportation costs
2. Different countries’ goods not perfect substitutes.
Yet, PPP is a useful theory:
It’s simple.
In the real world, nominal exchange rates
tend toward their PPP values over the long run.
A fiscal expansion in three
models
A fiscal expansion causes national saving to fall.
The effects of this depend on openness & size:
closed large open small open
economy economy economy
rises, but not as much no
r rises
as in closed economy change
falls, but not as much no
I falls
as in closed economy change
no falls, but not as much as
NX falls
change in small open economy
