5

CHAPTE
R

The Open Economy

MACROECONOMICS SIXTH EDITION

N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2007 Worth Publishers, all rights reserved
 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

CHAPTER 5 The Open Economy slide 2

 Trade-GDP ratio, selected countries,
2004
(Imports + Exports) as a percentage of GDP

Luxembourg 275.5% Germany 71.1%

Ireland 150.9 Turkey 63.6
Czech Republic 143.0 Mexico 61.2
Hungary 134.5 Spain 55.6
Austria 97.1 United Kingdom 53.8
Switzerland 85.1 France 51.7
Sweden 83.8 Italy 50.0
Korea, Republic of 83.7 Australia 39.6
Poland 80.0 United States 25.4
Canada 73.1 Japan 24.4

CHAPTER 5 The Open Economy slide 3

 In an open economy,

 spending need not equal output

 saving need not equal investment

CHAPTER 5 The Open Economy slide 4

 Preliminaries
superscripts:
d f
C C C d = spending on
d f domestic goods
I I I f = spending on
G G  G d 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
CHAPTER 5 The Open Economy slide 5
 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

CHAPTER 5 The Open Economy slide 6

 The national income identity
in an open economy

Y = C + I + G + NX

or, NX = Y – (C + I + G )

domestic
spending
net exports
output

CHAPTER 5 The Open Economy slide 7

 Trade surpluses and deficits

NX = EX – IM = Y – (C + I + G )

 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

CHAPTER 5 The Open Economy slide 8

 International capital flows

 Net capital outflow

=S –I
= net outflow of “loanable funds”
= net purchases of foreign assets
the country’s 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
CHAPTER 5 The Open Economy slide 10
 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 ).).
CHAPTER 5 The Open Economy slide 11
 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

CHAPTER 5 The Open Economy slide 13

 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

CHAPTER 5 The Open Economy slide 14

 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*

aa && bb imply
imply rr == r*
r*
cc implies
implies r*r* is
is exogenous
exogenous
CHAPTER 5 The Open Economy slide 15
 Investment:
The demand for loanable funds
Investment is still a
r
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

CHAPTER 5 The Open Economy slide 16

 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
CHAPTER 5 The Open Economy slide 17
 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
CHAPTER 5 The Open Economy slide 18
 Next, three experiments:

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

CHAPTER 5 The Open Economy slide 19

 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

NX1
Results:
I 0
NX S  0 I (r )

I1 S, I

CHAPTER 5 The Open Economy slide 20

 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
S, I
*
I (r )
2
I (r1* )

CHAPTER 5 The Open Economy slide 22

 3. An increase in investment
demand
r
S

r*
EXERCISE:
EXERCISE:
Use
Use the
the model
model to to NX
determine
determine the the impact
impact 1

of
of an
an increase
increase in in
investment I (r )1
investment demand
demand
on
on NX, S, I,I, and
NX, S, and
net I1 S, I
net capital
capital outflow.
outflow.

CHAPTER 5 The Open Economy slide 23

 3. An increase in investment
demand
r
S
ANSWERS:
ANSWERS: NX
I >
I > 0,0, r* 2

S =
S = 0,0,
net
net capital
capital NX
outflow
outflow and
and 1 I (r )2
NX
NX fall
fall by
by the
the
amount I
amount I I (r )1

I1 I2 S, I

CHAPTER 5 The Open Economy slide 24

 The nominal exchange rate

e = nominal exchange rate,

the relative price of
domestic currency
in terms of foreign currency
(e.g. Yen per Dollar)

CHAPTER 5 The Open Economy slide 25

 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 Big Macs per
U.S. Big Mac)

CHAPTER 5 The Open Economy slide 27

 Understanding the units of ε
e P
ε 
P*
(Yen per $) ($ per unit U.S. goods)

Yen per unit Japanese goods

Yen per unit U.S. goods


Yen per unit Japanese goods

Units of Japanese goods


per unit of U.S. goods

CHAPTER 5 The Open Economy slide 28

 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
 In our macro model:
There’s just one good, “output.”
So ε is the relative price of one country’s
output in terms of the other country’s output

CHAPTER 5 The Open Economy slide 30

 How NX depends on ε

ε  U.S. goods become more expensive

relative to foreign goods
 EX, IM
 NX

CHAPTER 5 The Open Economy slide 31

 The net exports function

 The net exports function reflects this inverse

relationship between NX and ε :

NX = NX(ε )

CHAPTER 5 The Open Economy slide 33

 The NX curve for the U.S.
ε

so U.S. net
When ε is exports will
relatively low, be high
U.S. goods are
relatively ε1
inexpensive
NX
0 ( ε)
NX(ε1) N
X
CHAPTER 5 The Open Economy slide 34
 The NX curve for the U.S.
ε At high enough
values of ε,
ε2 U.S. goods become
so expensive that
we export
less than
we import

NX
0 ( ε)
NX(ε2) N
X
CHAPTER 5 The Open Economy slide 35
 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 * )
CHAPTER 5 The Open Economy slide 36
 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

CHAPTER 5 The Open Economy slide 37

 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.
CHAPTER 5 The Open Economy slide 38
 Next, four experiments:

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

4. Trade policy to restrict imports

CHAPTER 5 The Open Economy slide 39

 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.
CHAPTER 5 The Open Economy slide 40
 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.
CHAPTER 5 The Open Economy slide 41
 3. Increase in investment
demand
An
An increase
increase in in S1  I 2
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 exchange
exchange ε1
market…
market…
NX(ε
…causing
…causing the the )
real NX
real exchange
exchange NX 2 NX 1
rate
rate to
to rise
rise and
and
NX
NX toto fall.
fall.
CHAPTER 5 The Open Economy slide 42
 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.
CHAPTER 5 The Open Economy slide 43
 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

CHAPTER 5 The Open Economy slide 44

 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

CHAPTER 5 The Open Economy slide 45

 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

CHAPTER 5 The Open Economy slide 46

 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
 For a given value of ε,
the growth rate of e equals the difference
between foreign and domestic inflation rates.
CHAPTER 5 The Open Economy slide 47
 Inflation differentials and nominal
exchange rates
35
Percentage Mexico
30
change in
nominal 25
exchange
20 Iceland
rate
15
10 Singapore
South Africa
Canada
5 South Korea
_
0 U.K.
Japan
-5
-5 0 5 10 15 20 25 30
Inflation differential
CHAPTER 5 The Open Economy slide 48
 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

CHAPTER 5 The Open Economy slide 49

 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.
CHAPTER 5 The Open Economy slide 50
 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
CHAPTER 5 The Open Economy slide 51
 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:

 It’s simple & intuitive
 In the real world, nominal exchange rates
tend toward their PPP values over the long run.

CHAPTER 5 The Open Economy slide 52

 The U.S. as a large open
economy
 So far, we’ve learned long-run models for
two extreme cases:
 closed economy (chap. 3)
 small open economy (chap. 5)
 A large open economy – like the U.S. – falls
between these two extremes.
 The results from large open economy analysis
are a mixture of the results for the
closed & small open economy cases.
 For example…
CHAPTER 5 The Open Economy slide 54
 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
CHAPTER 5 The Open Economy slide 55