1Chapter Five

CHAPTER 5The Open Economy

®

A PowerPointTutorialTo Accompany

MACROECONOMICS, 6th. ed.N. Gregory Mankiw

By

Mannig J. Simidian

2Chapter Five

When an economy is so-called, “open,” it means that a country’sspending in any given year is not equal to its output of goods andservices. A country can spend more that it produces by borrowingfrom abroad, or it can spend less and lend the difference to foreigners.Let’s turn to national income accounting to explain.

3Chapter Five

Governmentpurchases of goods

and services

Governmentpurchases of goods

and services

Y = C + I + G + NXY = C + I + G + NX

Total demandfor domestic

output

Total demandfor domestic

output

Consumptionspending byhouseholds

Consumptionspending byhouseholds

Investmentspending by

businesses andhouseholds

Investmentspending by

businesses andhouseholds

Net exportsor net foreign

demand

Net exportsor net foreign

demand

Notice we’ve added net exports, NX, defined as EX - IM. Also, note that domestic spending on all goods and services is the sum of domestic spending on domestics goods and services and on foreign goods and services.

is composed of

is composed of

4Chapter Five

Y = C + I + G + NXY = C + I + G + NX

After some manipulation, the national income accounts identity can be re-written as:

NX = Y - (C + I + G)NX = Y - (C + I + G)

Net ExportsNet Exports OutputOutput

This equation shows that in an open economy, domestic spending neednot equal the output of goods and services. If output exceeds domesticspending, we export the difference: net exports are positive. If outputfalls short of domestic spending, we import the difference: net exportsare negative.

Domestic Spending

Domestic Spending

5Chapter Five

Start with the national income accounts identity. Y = C + I + G + NX.Subtract C and G from both sides and obtain Y – C - G = I + NX.

Let’s call this S, national saving.

So, now we have S = I + NX. Subtract I from both sides to obtain the new equation, S – I = NX.This form of the national income accounts identity shows that an economy’s net exports must always equal the difference between itssaving and its investment.

S – I = NX

Trade BalanceNet Foreign Investment

6Chapter Five

S – I = NXS – I = NXIf S - I and NX are positive, we have a trade surplus. We would be net lenders in world financial markets, and we are exporting more goods than we are importing.

If S - I and NX are negative, we have a trade deficit. We would be netborrowers in world financial markets, and we are importing more goods than we are exporting.

If S - I and NX are exactly zero, we have balanced trade since the valueof imports equals the value of exports.

Net Capital Outflow = Trade Balance

7Chapter Five

A bilateral trade balance between two countries means that the value of what a country sells to one country is equal to the value of what it buys from that country. For example, there would be abilateral trade balance between the United States. and China if the United States buys a pair of shoes from China valued at $300, but also sells a pair of jeans to China for $300.

A nation can have large trade deficits and surpluses with differentcountries but have balanced trade overall. For example, there wouldbe balanced trade overall if the United States sells a $300 pair of jeans to Japan, Japan sells a $300 car seat to China, and China sells a $300 pair of shoes to the United States. In this case, each country that bought something without having sold something to the country it bought the good from has a bilateral trade deficit. But, each nation has balanced trade overall, exporting and importing $300 worth of goods.

8Chapter Five

We are now going to develop a model of the international flows of capital and goods.

Then, we’ll address issues such as how the trade balance responds to changes in policy.

9Chapter Five

Recall that the trade balance equals the net capital outflow, which in turn equals saving minus investment. Our model focuses on savingand investment. We’ll borrow a part of the model from Chapter 3, butwon’t assume that the real interest rate equilibrates saving andinvestment. Instead, we’ll allow the economy to run a trade deficitand borrow from other countries, or to run a trade surplus and lendto other countries.

Consider a small open economy with perfect capital mobility inwhich it takes the world interest rate r* as given, denoted r = r*.

Remember in a closed economy, what determines the interest rate is theequilibrium of domestic saving and investment--and in a way, the worldis like a closed economy—therefore, the equilibrium of world saving and world investment determines the world interest rate.

10Chapter Five

C = C (Y-T)

I = I (r)

Y = Y = F(K, L)

NX = (Y-C-G) - I or NX = S - I

The economy’s output Y is fixed by thefactors of production and the productionfunction.Consumption is positively related to disposable income (Y - T).Investment is negatively related to thereal interest rate.The national income accounts identity,expressed in terms of saving and investment.

Now substitute our three assumptions from Chapter 3 and the assumptionthat the interest rate equals the world interest rate, r*.

NX = (Y-C(Y-T) - G) - I (r*)NX = S - I (r*)

This equation suggests that the trade balance is determined by thedifference between saving and investment at the world interest rate.

11Chapter Five

Suppose the economy begins in a position of balanced trade. In other words, at the world interest rate, investment I equals savings S,and net exports equal zero. Let’s use our model to predict theeffects of government policies at home or abroad.

12Chapter Five

S

I(r)

Investment, Saving, I, S

Real interest rate, r*

rclosed

r*

NX

In a closed economy, r adjusts to equilibrate saving and investment.

In a small open economy, the interest rate is set by worldfinancial markets. The differencebetween saving and investmentdetermines the trade balance.

Hence, starting from balanced trade, an increasein the world interest rate due to a fiscal expansion abroad leads to a trade surplus.

r*'NX

If the world interest rate decreased to r* ', I would exceed S and there would be a trade deficit.

In this case, since r* is Above rclosed and savingexceeds investment, there is a trade surplus.

13Chapter Five

S

I(r)

Investment, Saving, I, S

Real interest rate, r*

r*

S'

An increase in government purchases or a cut in taxes decreases national saving and thus shifts the national saving schedule to the left.

NX

The result is a reduction in national saving which leads to a trade deficit, where I > S.

NX = (Y - C(Y - T) - G) - I (r*)

NX = S - I (r*)

14Chapter Five

S

I(r)

Investment, Saving, I, S

Real interest rate, r*

r1*

A fiscal expansion in a foreign economy large enough to influence world saving and investment raises the world interest rate from r1* to r2*.

NX

The higher world interest rate reduces investment in this small open economy, causing a trade surpluswhere S > I.

r2*

15Chapter Five

An outward shift in the investment schedule from I(r)1 to I(r)2 increases the amount of investment at the world interest rate r*.

NX

As a result, investment now exceeds saving I > S, which means the economy isborrowing from abroad and running a trade deficit.

S

I(r)1

Investment, Saving, I, S

Real interest rate, r*

r1* I(r)2

16Chapter Five

In the next few slides, we’ll learn about the foreign exchange market, exchange rates and much more!

17Chapter Five

Let’s think about when the United States and Japan engage in trade. Each country has different cultures, languages, and currencies, all of which could hinder trade. But, because of the foreign exchange market, trade transactions become more efficient. The foreign exchange market is a global market in which banks are connected through high-tech telecommunications systems in order to purchase currencies for their customers.

The next slide is a graphical representation of the flow of the trade between the United States and Japan, and how the mix of traded things might be different, but is always balanced. Also, notice how the foreign exchange market will play the middle-man in these transactions. For instance, the foreign exchange market converts the supply of dollars from the United States into the demand for yen, and conversely, the supply of yen into the demand for dollars.

18Chapter Five

it must supply yen which are then converted into dollars by the foreign exchange market.

ForeignExchange

Market

ForeignExchange

Market

Supply$DemandYEN

Demand$SupplyYEN

In order for Japan to pay for its imports of goods and services and securities from the U.S.,

In order for the U.S to pay for its imports of goods and services and securities from Japan,it must supply dollars which are then converted

into yen by the foreign exchange market.

& SecuritiesGOODS & SERVICES

GOODS & SERVICES

Goods and Services& SECURITIES

SECURITIES

19Chapter Five

The exchange rate between two countries is the price at whichresidents of those countries trade with each other. The nominal

exchange rate is the relative price of the currency of twocountries.

20Chapter Five

-relative price of the currency of two countries-denoted as e -relative price of the currency of two countries-denoted as e

-relative price of the goods of two countries-sometimes called the terms of trade-denoted as

-relative price of the goods of two countries-sometimes called the terms of trade-denoted as

21Chapter Five

The nominal exchange rate is the relative price of the currency oftwo countries. For example, if the exchange rate between the U.S.dollar and the Japanese yen is 120 yen per dollar, then you canexchange a dollar for 120 yen in world markets for foreign currency.A Japanese who wants to obtain dollars would pay 120 yen for eachdollar he bought. An American who wants to obtain yen would get120 yen for each dollar he paid. When people refer to “the exchangerate” between two countries, they usually mean the nominal exchangerate.

The nominal exchange rate is the relative price of the currency oftwo countries. For example, if the exchange rate between the U.S.dollar and the Japanese yen is 120 yen per dollar, then you canexchange a dollar for 120 yen in world markets for foreign currency.A Japanese who wants to obtain dollars would pay 120 yen for eachdollar he bought. An American who wants to obtain yen would get120 yen for each dollar he paid. When people refer to “the exchangerate” between two countries, they usually mean the nominal exchangerate.

22Chapter Five

D$ shifts rightward and increases the nominal exchange rate, e. This is known as appreciation of the dollar.

Be1

e

Dollar Value of Transactions

D$

Ae0

S$

$

Suppose that there is an increase in the demand for U.S. goods andservices. How will this affect the nominal exchange rate?

Events which decrease the demand for the dollar, and thus decrease e, would be a depreciation of the dollar.

D$

23Chapter Five

The real exchange rate is the relative price of the goods of two countries. That is, the real exchange rate tells us the rate at which we can trade the goods of one country for the goods of another.

To see the difference between the real and nominal exchange rates, consider a single good produced in many countries: cars. Suppose anAmerican car costs $10,000 and a similar Japanese car costs 2,400,000yen. To compare the prices of the two cars, we must convert them intoa common currency. If a dollar is worth 120 yen, then the Americancar costs 1,200,000 yen. Comparing the price of the American car(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), weconclude that the American car costs one-half of what the Japanesecar costs. In other words, at current prices, we can exchange twoAmerican cars for one Japanese car.

24Chapter Five

We can summarize our calculation as follows:Real Exchange Rate = (120 yen/dollar) (10,000 dollars/American car)

(2,400,000 yen/Japanese Car) = 0.5 Japanese Car

American CarAt these prices, and this exchange rate, we obtain one-half of a Japanesecar per American car. More generally, we can write this calculation as Real Exchange Rate =

Nominal Exchange Rate Price of Domestic Good Price of Foreign Good

The rate at which we exchange foreign and domestic goods depends onthe prices of the goods in the local currencies and on the rate at whichthe currencies are exchanged.

25Chapter Five

= e × (P/P*)

Real Exchange Rate

Nominal Exchange

RateRatio of Price

Levels

Note: P is the price level of the domestic country (measured in the domestic currency) and P* is the price level of theforeign country (measured in the foreign currency).

26Chapter Five

= e × (P/P*)

The real exchange rate between two countries is computed from the nominal exchange rate and the price levels in the two countries. If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. If the real exchange rate is low, foreign goods are relatively expensive, and domestic goodsare relatively cheap.

Real Exchange Rate

Nominal Exchange Rate

Ratio of Price Levels

27Chapter Five

How does the level of prices effect exchange rates? It doesn’t. All changes in a nation’s price level will be fully incorporated into the nominal exchange rate. It is the law of one price applied to the international marketplace.

Purchasing-Power Parity suggests that nominal exchange rate movements primarily reflect differences in price levels of nations. It states that if international arbitrage is possible, then a dollar must have the same purchasing power in every country. Purchasing power parity does not always hold because some goods are not easily traded, and sometimes traded goods are not always perfect substitutes—but it does give us reason to expect that fluctuations in the real exchange rate will be small and temporary.

28Chapter Five

NX()

Net Exports, NX

Real exchangerate,

The law of one price applied to the international marketplace suggests thatnet exports are highly sensitive to smallmovements in the real exchange rate.This high sensitivity is reflected herewith a very flat net-exports schedule.

S-I

29Chapter Five

NX()

Net Exports, NX

Real exchangerate,

0

The real exchange rate is determined by theintersection of the vertical line representingsaving minus investment and downward-slopingnet exports schedule.

S-I

The relationship between the real exchange rate and net exports is negative: the lower the real exchange rate, the less expensive are domestic goods relative to foreign goods, and thus the greater are our net exports.

Here the quantity of dollars supplied for net foreigninvestment equals the quantity of dollars demandedfor the net exports of goods and services.

30Chapter Five

NX()

Net Exports, NX

Real exchangerate,

NX1

The fall in saving reduces the supply of dollarsto be exchanged into foreign currency, fromS1-I to S2-I. This shift raises the equilibrium realexchange rate from 1 to 2.

S1- IExpansionary fiscal policy at home, such as anincrease in government purchases G or a cut intaxes, reduces national saving.

A reduction in saving reduces the supply of dollars, which causes the real exchange rate to rise and causes net exports to fall.

S2 - I

NX2

2

1

31Chapter Five

NX()

Net Exports, NX

Real exchangerate,

NX2

The increase in the world interest rate reducesinvestment at home, which in turn raises thesupply of dollars to be exchanged into foreigncurrencies.

S - I (r2*) Expansionary fiscal policy abroad reduces world saving and raises the world interest rate from r1* to r2*.

As a result, the equilibriumreal exchange rate falls from e1 to e2.

NX1

1

2

S - I(r1*)

32Chapter Five

NX()

Net Exports, NX

Real exchangerate,

NX1

As a result, the supply of dollars to be exchanged into foreign currencies falls from S - I1 to S - I2.

S - I1An increase in investment demand raises the quantity of domestic investment from I1

to I2.

This fall in supply raises the equilibrium real exchange rate from 1 to 2.

NX2

1

2

S - I2

33Chapter Five

Net exportsNet capital outflowTrade balanceTrade surplus and trade deficitBalanced tradeSmall open economyWorld interest rateNominal exchange rateReal exchange ratePurchasing-power parity