C H A P T E R

The Open Economy

University of Wisconsin
Charles Engel
5
slide 1
CHAPTER 5.01
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
slide 2
CHAPTER 5.01
Trade-GDP ratio, selected countries, 2004
(Imports + Exports) as a percentage of GDP
Luxembourg 275.5%
Ireland 150.9
Czech Republic 143.0
Hungary 134.5
Austria 97.1
Switzerland 85.1
Sweden 83.8
Korea, Republic of 83.7
Poland 80.0
Canada 73.1
Germany 71.1%
Turkey 63.6
Mexico 61.2
Spain 55.6
United Kingdom 53.8
France 51.7
Italy 50.0
Australia 39.6
United States 25.4
Japan 24.4
slide 3
CHAPTER 5.01
In an open economy,
spending need not equal output
saving need not equal investment
slide 4
CHAPTER 5.01
Preliminaries
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
d f
C C C = +
d f
I I I = +
d f
G G G = +
superscripts:
d = spending on
domestic goods
f = spending on
foreign goods
slide 5
CHAPTER 5.01
GDP = expenditure on
domestically produced g & s
d d d
Y C I G EX = + + +
( ) ( ) ( )
f f f
C C I I G G EX = + + +
( )
f f f
C I G EX C I G = + + + + +
C I G EX IM = + + +
C I G NX = + + +
slide 6
CHAPTER 5.01
The national income identity
in an open economy
Y = C + I + G + NX
or, NX = Y (C + I + G )
net exports
domestic
spending
output
slide 7
CHAPTER 5.01
Trade surpluses and deficits
trade surplus:
output > spending and exports > imports
Size of the trade surplus = NX
trade deficit:
spending > output and imports > exports
Size of the trade deficit = NX
NX = EX IM = Y (C + I + G )
U.S. net exports, 1950-2006
U.S. Net Exports, 1950-2006
-800
-600
-400
-200
0
200
1950 1960 1970 1980 1990 2000
b
i
l
l
i
o
n
s

o
f

d
o
l
l
a
r
s
-8%
-6%
-4%
-2%
0%
2%
p
e
r
c
e
n
t

o
f

G
D
P
NX ($ billions) NX (% of GDP)
slide 9
CHAPTER 5.01
International capital flows
Net capital outflow
= S I
= net outflow of loanable funds
= net purchases of foreign assets
the countrys purchases of foreign assets
minus foreign purchases of domestic assets
When S > I, country is a net lender
When S < I, country is a net borrower
slide 10
CHAPTER 5.01
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,
a country with a trade deficit (NX < 0)
is a net borrower (S < I ).
slide 11
CHAPTER 5.01
The worlds largest debtor nation
U.S. has had large trade deficits, been a
net borrower each year since the early 1980s.
As of 12/31/2005:
U.S. residents owned $10.0 trillion worth of
foreign assets
Foreigners owned $12.7 trillion worth of U.S.
assets
U.S. net indebtedness to rest of the world:
$2.7 trillion--higher than any other country,
hence U.S. is the worlds largest debtor nation
slide 12
CHAPTER 5.01
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
consumption function
investment function
exogenous policy variables
Y Y F K L = = ( , )
C C Y T = ( )
I I r = ( )
G G T T = = ,
slide 13
CHAPTER 5.01
National saving:
The supply of loanable funds
r
S, I
As in Chapter 3,
national saving does
not depend on the
interest rate
( ) S Y C Y T G =
S
slide 14
CHAPTER 5.01
Assumptions re: 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 imply r = r*
c implies r* is exogenous
slide 15
CHAPTER 5.01
Investment:
The demand for loanable funds
Investment is still a
downward-sloping function
of the interest rate,
r *
but the exogenous
world interest rate
determines the
countrys level of
investment.
I (r* )
r
S, I
I (r )
slide 16
CHAPTER 5.01
If the economy were closed
r
S, I
I (r )
S
r
c
c
I
S
r
=
( )
the interest
rate would
adjust to
equate
investment
and saving:
slide 17
CHAPTER 5.01
But in a small open economy
r
S, I
I (r )
S
r
c
r*

I
1
the exogenous
world interest
rate determines
investment
and the
difference
between saving
and investment
determines net
capital outflow
and net exports
NX
slide 18
CHAPTER 5.01
Next, three experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
slide 19
CHAPTER 5.01
1. Fiscal policy at home
r
S, I
I (r )
1
S
I
1
An increase in G
or decrease in T
reduces saving.
1
*
r
NX
1
2
S
NX
2
Results:

0 I A =
0 NX S A = A <
NX and the federal budget deficit
(% of GDP), 1960-2006
-6%
-4%
-2%
0%
2%
4%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
-4%
-2%
0%
2%
4%
6%
8%
Net exports
(left scale)
Budget deficit
(right scale)
slide 20
slide 21
CHAPTER 5.01
2. Fiscal policy abroad
r
S, I
I (r )
1
S
Expansionary
fiscal policy
abroad raises
the world
interest rate. 1
*
r
NX
1
NX
2
Results:

0 I A <
0 NX I A = A >
2
*
r
1
( )
*
I r
2
( )
*
I r
slide 22
CHAPTER 5.01
3. An increase in investment demand
r
S, I
I (r )
1
EXERCISE:
Use the model to
determine the impact
of an increase in
investment demand
on NX, S, I, and
net capital outflow.
NX
1
*
r
I
1
S

slide 23
CHAPTER 5.01
3. An increase in investment demand
r
S, I
I (r )
1
ANSWERS:
AI > 0,
AS = 0,
net capital
outflow and
NX fall by the
amount AI
NX
2
NX
1
*
r
I
1
I
2
S

I (r )
2
slide 24
CHAPTER 5.01
Is the US Current Account Deficit
Dangerous? (Coughlin, Pakko and
Poole)
These authors note that the US is running large
current account deficits: I > S.
The US is accumulating debt.
The US debt/GDP ratio is rising.
Yet they say there may not be reason to worry.
The current account deficit represents capital
inflows. These inflows might be occurring
because of confidence in the US economy and
the belief that US assets are good investments.
slide 25
CHAPTER 5.01
The Optimistic View in terms of
our model
A simple, optimistic view of the current account deficit is
that the world expects high productivity growth and
output growth in the US.
For any given r, this increases investment demand.
In addition, saving may be low compared to other
economies that do not expect fast growth.
The S curve is shifted left, the I curve is shifted right.
The US can afford to accumulate debt because its real
GDP will be high in the future.
Other countries need to worry more about their aging
populations.
slide 26
CHAPTER 5.01
The nominal exchange rate
e = nominal exchange rate,
the relative price of
domestic currency
in terms of foreign currency
(e.g. Yen per Dollar)
slide 27
CHAPTER 5.01
A few exchange rates, as of 7/14/06
country exchange rate
Euro 0.79 Euro/$
Indonesia 9,105 Rupiahs/$
Japan 116.3 Yen/$
Mexico 11.0 Pesos/$
Russia 27.0 Rubles/$
South Africa 7.2 Rand/$
U.K. 0.54 Pounds/$
slide 28
CHAPTER 5.01
The real exchange rate
= real exchange rate,
the relative price of
domestic goods
in terms of foreign goods
(e.g. Japanese Big Macs per
U.S. Big Mac)
the lowercase
Greek letter
epsilon

slide 29
CHAPTER 5.01
Understanding the units of
(Yen per $) ($ per unit U.S. goods)
Yen per unit Japanese goods

=
Units of Japanese goods

per unit of U.S. goods
=
Yen per unit U.S. goods
Yen per unit Japanese goods
=
*
e P
P

=
one good: Big Mac
price in Japan:
P* = 200 Yen
price in USA:
P = $2.50
nominal exchange rate
e = 120 Yen/$
To buy a U.S. Big Mac,
someone from Japan
would have to pay an
amount that could buy
1.5 Japanese Big Macs.
120 2 50
1 5
200 Yen
e P
P

= =
*
$ .
.

~ McZample ~
CHAPTER 5 The Open Economy
slide 30
slide 31
CHAPTER 5.01
in the real world & our model
In the real world:
We can think of as the relative price of
a basket of domestic goods in terms of a
basket of foreign goods
In our macro model:
Theres just one good, output.
So is the relative price of one countrys
output in terms of the other countrys output
slide 32
CHAPTER 5.01
How NX depends on
| U.S. goods become more expensive
relative to foreign goods
+EX, |IM
+NX
slide 33
CHAPTER 5.01
U.S. net exports and the
real exchange rate, 1973-2006
-7%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
1973 1977 1981 1985 1989 1993 1997 2001 2005
N
X

(
%

o
f

G
D
P
)

0
20
40
60
80
100
120
140
I
n
d
e
x


(
M
a
r
c
h

1
9
7
3

=

1
0
0
)

Trade-weighted real
exchange rate index
Net exports
(left scale)
slide 34
CHAPTER 5.01
The net exports function
The net exports function reflects this inverse
relationship between NX and :
NX = NX( )
slide 35
CHAPTER 5.01
The NX curve for the U.S.
0
NX

NX ()

1

When is
relatively low,
U.S. goods are
relatively
inexpensive
NX(
1
)
so U.S. net
exports will
be high
slide 36
CHAPTER 5.01
The NX curve for the U.S.
0
NX

NX ()

2

At high enough
values of ,
U.S. goods become
so expensive that
NX(
2
)
we export
less than
we import
slide 37
CHAPTER 5.01
How 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, must adjust to ensure
( ) ( ) * NX S I r =
slide 38
CHAPTER 5.01
How is determined
Neither S nor I
depend on ,
so the net capital
outflow curve is
vertical.

NX
NX( )
1
( *) S I r
adjusts to
equate NX
with net capital
outflow, S I.

1
NX
1
slide 39
CHAPTER 5.01
Interpretation: Supply and demand
in the foreign exchange market
demand:
Foreigners need
dollars to buy
U.S. net exports.

NX
NX( )
1
( *) S I r
supply:
Net capital
outflow (S I )
is the supply of
dollars to be
invested abroad.

1
NX
1
slide 40
CHAPTER 5.01
Next, four experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
4. Trade policy to restrict imports
slide 41
CHAPTER 5.01
1. Fiscal policy at home
A fiscal expansion
reduces national
saving, net capital
outflow, and the
supply of dollars
in the foreign
exchange
market
causing the real
exchange rate to
rise and NX to fall.

NX
NX( )
1
( *) S I r

1
NX
1
NX
2
2
( *) S I r

2
slide 42
CHAPTER 5.01
2. Fiscal policy abroad
An increase in r*
reduces
investment,
increasing net
capital outflow
and the supply of
dollars in the
foreign exchange
market
causing the real
exchange rate to fall
and NX to rise.

NX
NX( )
1 1
( *) S I r
NX
1

1
2 1
( ) * S I r

2
NX
2
slide 43
CHAPTER 5.01
3. Increase in investment demand
An increase in
investment
reduces net
capital outflow
and the supply
of dollars in the
foreign exchange
market

NX
NX( )
causing the
real exchange
rate to rise and
NX to fall.

1
1 1
S I
NX
1
2 1
S I
NX
2

2
slide 44
CHAPTER 5.01
4. Trade policy to restrict imports

NX
NX ( )
1
S I
NX
1

1
NX ( )
2
At any given value of
, an import quota
+IM |NX
demand for
dollars shifts
right
Trade policy doesnt
affect S or I , so
capital flows and the
supply of dollars
remain fixed.

2
slide 45
CHAPTER 5.01
4. Trade policy to restrict imports

NX
NX ( )
1
S I
NX
1

1
NX ( )
2
Results:
A > 0
(demand
increase)
ANX = 0
(supply fixed)
AIM < 0
(policy)
AEX < 0
(rise in )

2
slide 46
CHAPTER 5.01
The determinants of the
nominal exchange rate
Start with the expression for the real exchange
rate:
*
e P

=
Solve for the nominal exchange rate:
*
P
e
P
=
slide 47
CHAPTER 5.01
The determinants of the
nominal exchange rate
( * , )
M
L r Y
P
= +t
( ) ( ) * NX S I r =
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
P
=
*
* *
*
( * *, )
M
L r Y
P
= + t
slide 48
CHAPTER 5.01
The determinants of the
nominal exchange rate
Rewrite this equation in growth rates
(see arithmetic tricks for working with percentage
changes, Chap 2 ):
*
P
e
P
=
*
*
e P P
e P P
= +
A A A A
*

t t = +
A
For a given value of ,
the growth rate of e equals the difference
between foreign and domestic inflation rates.
slide 49
CHAPTER 5.01
Inflation differentials and nominal
exchange rates
-5
0
5
10
15
20
25
30
35
-5 0 5 10 15 20 25 30
Inflation differential
Percentage
change in
nominal
exchange
rate
_
U.K.
South Africa
Iceland
Mexico
South Korea
Canada
Singapore
Japan
slide 50
CHAPTER 5.01
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
slide 51
CHAPTER 5.01
Purchasing Power Parity (PPP)
PPP: e P = P*
Cost of a basket of
domestic goods, in
foreign currency.
Cost of a basket of
domestic goods, in
domestic currency.
Cost of a basket of
foreign goods, in
foreign 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.
slide 52
CHAPTER 5.01
Purchasing Power Parity (PPP)
If e = P*/P,
then
*
* *
1
P P P
e
P P P
= = =
and the NX curve is horizontal:

NX
NX
= 1

S I

Under PPP,
changes in
(S I ) have no
impact on or e.
slide 53
CHAPTER 5.01
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.
Nonetheless, PPP is a useful theory:
Its simple & intuitive
In the real world, nominal exchange rates
tend toward their PPP values over the long run.
slide 54
CHAPTER 5.01
no change
no change
+
|
+
|
|
+
no change
no change
+
|
|
+
+
|
+
|
129.4
-2.0
19.4
6.3
17.4
3.9
115.1
-0.3
19.9
1.1
19.6
2.2
closed
economy
small open
economy
actual
change

NX
I
r
S
G T
1980s 1970s
Data: decade averages; all except r and are expressed as a percent of GDP;
is a trade-weighted index.
CASE STUDY:
The Reagan deficits revisited
Chapter Summary
Net exports--the difference between
exports and imports
a countrys output (Y )
and its spending (C + I + G)
Net capital outflow equals
purchases of foreign assets
minus foreign purchases of the countrys assets
the difference between saving and investment
CHAPTER 5 The Open Economy
slide 55
Chapter Summary
National income accounts identities:
Y = C + I + G + NX
trade balance NX = S I net capital outflow

Impact of policies on NX :
NX increases if policy causes S to rise
or I to fall
NX does not change if policy affects
neither S nor I. Example: trade policy
CHAPTER 5 The Open Economy
slide 56
Chapter Summary
Exchange rates
nominal: the price of a countrys currency in
terms of another countrys currency
real: the price of a countrys goods in terms of
another countrys goods
The real exchange rate equals the nominal rate
times the ratio of prices of the two countries.
CHAPTER 5 The Open Economy
slide 57
Chapter Summary
How the real exchange rate is determined
NX depends negatively on the real exchange
rate, other things equal
The real exchange rate adjusts to equate
NX with net capital outflow
CHAPTER 5 The Open Economy
slide 58
Chapter Summary
How the nominal exchange rate is determined
e equals the real exchange rate times the
countrys price level relative to the foreign price
level.
For a given value of the real exchange rate, the
percentage change in the nominal exchange
rate equals the difference between the foreign &
domestic inflation rates.
CHAPTER 5 The Open Economy
slide 59