OPEN ECONOMYSource of text materials: Mankiw (2009) Macroeconomics, 7th Ed.Source of data materials: World Bank

Imports and exports as a percentage of output: ASEAN, 2010

The International Flow of Capital and Goods

The Role of Net Exports In an open economy, some output is sold

domestically and some is exported to be sold abroad.

Then, the output Y is expressed in the identity:Y = Cᵈ + Iᵈ + Gᵈ + X

Cᵈ = consumption of domestic goods & servicesIᵈ = investment in domestic goods & servicesGᵈ = gov’ purchases of domestic goods & servicesX = exports of domestic goods & services

The International Flow of Capital and Goods

Note that all domestic spending are equals domestic spending on domestic goods & services plus domestic spending on foreign goods & services. So:

C = Cᵈ + Cᶠ I = Iᵈ + IᶠG = Gᵈ + Gᶠ

Y = (C – Cᶠ) + (I – Iᶠ) + (G – Gᶠ) + XY = C + I + G + X – (Cᶠ + Iᶠ + Gᶠ)Y = C + I + G + X – IMY = C + I + G + NX

Substitute into : Y = Cᵈ + Iᵈ + Gᵈ + X

The International Flow of Capital and Goods

Therefore, we can conclude that:

NX = Y – (C + I + G)

If output exceeds domestic spending, we export the difference: net exports are positive (NX > 0).

If output falls short of domestic spending, we import the difference: net exports are negative (NX < 0).

Net Exports Output Domestic Spending

The International Flow of Capital and Goods

International Capital Flows & the Trade Balance

Recall from Chapter 3: financial markets and goods markets are closely related.

Y =C + I + G + NXY – C – G = I + NX

S = I + NXS – I =NX

Net Capital Outflow

=Trade Balance

Saving & Investment in a Small Open Economy

Capital Mobility & the World Interest Rate

Since the trade balance equals net capital outflow, our model focuses on saving and investment.

Instead of using equilibrium interest rate, we rather use world interest rate (r*) because the economy may run a trade surplus or trade deficit.

r = r * However, this is represents the case of small

open economy with perfect capital mobility.

Saving & Investment in a Small Open Economy

Saving and investment in small open economy:r

I, S0

I(r)

S

r*NX

Saving & Investment in a Small Open Economy

How Policies Influence the Trade Balance

Fiscal Expansion at Homean increase in government expenditure or a reduction in taxes reduces national saving, thus: trade deficit.

Fiscal Expansion Abroada fiscal expansion at foreign big open economy is strong enough to raise the world interest rate, thus: trade surplus.

Shift in the Investment Schedulean outward shift in investment schedule increases the actual investment at r* and exceeds saving, thus: trade deficit.

Exchange Rates

“Is the price of which residents of two countries trade with each other

during the trade transaction.”

Exchange Rates

Nominal & Real Exchange Rates The Nominal Exchange Rates

is the relative price of the currencies of two countries.

Appreciation is the rise in the exchange rate (strengthening of the currency)

Depreciation is the fall in the exchange rate (weakening of the currency)

Exchange Rate =

Foreign Currency

Local Currency

Exchange Rates

Trend in Rupiah’s exchange rate:

Exchange Rates

Comparison in ASEAN’s currency exchange rate (2011):

Country $/Local Local/$Singapore 0.795054205 1.2578Brunei Darussalam 0.794967525 1.2579Malaysia 0.326797064 3.0600Thailand 0.032795774 30.4917Philippines 0.023087684 43.3131Cambodia 0.000246396 4058.5000Lao 0.000121083 8258.7701Indonesia 0.000114019 8770.4333Vietnam 0.000048757 20509.7500

Exchange Rates

The Real Exchange Ratesis the relative price of the goods of two countries (also known as terms of trade).

If the real exchange rate (ϵ) is high, foreign goods are relatively cheap, and domestic goods are relatively expensive.

Real Exchange Rate =

Nominal Exchange Rate x Domestic PriceForeign Price

ϵ = e PP*

Exchange Rates

The Real Exchange Rate & the Trade Balance

Since the real exchange rate express the price ratio of domestic goods to foreign goods, it affects the demand for these goods (which turns into Net Exports = NX).

NX = NX(ϵ)

Low exchange rate → cheap domestic goods → exports

High exchange rate → cheap foreign goods → imports

Exchange Rates

Relationship between real exchange rate and net export:

ϵ

Net Exports0

NX(ϵ)

Exchange Rates

The Determinant of the Real Exchange Rate

1.The real exchange rate (ϵ) is related to net exports (NX). It appears to has negative correlation.

2.The trade balance (the net exports) must equal to net capital outflow, which in turn equals to savings minus investment (S-I). Saving is fixed by the consumption function and fiscal policy; Investment is fixed by the investment function and world interest rate.

Exchange Rates

How Policies Influence the Real Exchange Rate

Fiscal Expansion at Homean increase in government expenditure or a reduction in taxes reduces national saving, thus: increasing ϵ, decreasing NX.

Fiscal Expansion Abroada fiscal expansion at foreign big open economy is strong enough to raise the world interest rate and reduce world saving, thus: decreasing ϵ, increasing NX.

Shift in the Investment Schedulean outward shift in investment schedule increases the actual domestic investment, thus: increasing ϵ, decreasing NX.

Exchange Rates

How the real exchange rate is determined:

Net Exports

NX(ϵ)

S-Iϵ

ϵ*

Exchange Rates

The Effect of Trade Policies Protectionist Trade Policies

a ban on imported commodities or a regulate on particular import quota or impose a tariff on imported commodities would raise the demand for net exports, thus: increasing ϵ, unchanged NX (because the protectionist trade policy does alter neither saving nor investment).

Exchange Rates

The Determinants of the Nominal Exchange Rate

Recall the relationship of two exchange rates:ϵ = e

PP*

Δe=

Δϵ+

ΔP* – ΔPe ϵ P* P

e = ϵP*P

Δe=

Δϵ+ ( π

* – π )e ϵ

Exchange Rates

The Special Case of PPP The Law of One Price states that the same

good cannot sell for different prices in different places at the same time.

Arbitrageurs are people who specialize in ‘buying low’ in one market and ‘selling high’ in another. This opportunistic thereby ensuring that prices are equalized in the two markets.

Purchasing Power Parity (PPP) is the international term for the Law of One Price. If international arbitrage is possible, then a currency must have the same purchasing power in every country.

Exchange Rates

PPP suggested that NX are highly sensitive to ϵ:

Net Exports

NX(ϵ)

S-Iϵ

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