Open Economy Macroeconomics

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 Imports and Exports
as a percentage of output
40
Percentage
of GDP 35

30

25

20

15

10

0
Canada France Germany Italy Japan U.K. U.S.
Imports Exports
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 Preliminaries
superscripts:
d =spending on
domestic
goods
f = spending on
foreign goods

EX = exports =
foreign spending on domestic
goods
IM = imports = C f + I f + G f
= spending on foreign goods
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 Preliminaries, cont.
NX = net exports (the “trade
balance”)
= EX – IM
If NX > 0,
country has a trade surplus
equal to NX
If NX < 0,
country has a trade deficit
equal to – NX
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 GDP = expenditure on
domestically produced g & s

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 The national income identity
in an open economy

Y = C + I + G + NX
or, NX = Y – (C + I + G )

domestic
spending
net
exports
output

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 International capital flows
 Net capital outflows
= 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

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 Another important identity
NX
NX == YY –– (C
(C + + II +
+G G))
implies
implies
NX
NX == (Y(Y –– CC –– G
G)) –– II
== SS –– II
trade
trade balance
balance == net
net capital
capital
outflows
outflows
Private
Private saving
saving =
= YY −
− TT −
− C,
C, and
and
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public
public saving
saving =
= TT −
−G G
 International Flows of Goods
and Capital: Summary

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 Quick Quiz
If net capital outflow is positive, then:

A) exports must be positive.

B) exports must be negative.
C) the trade balance must be positive.
D) the trade balance must be negative.

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 Saving and investment in a
small open economy
An open-economy version of the
loanable funds model from previous
lectures.
Includes many of the same
elements:

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 National saving:
The supply of loanable
funds
r

national saving
does not depend
on the interest
rate

S S, I
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 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*
aa && bb imply
imply rr =
= r*
r*
cc implies
implies r*
r* is
is exogenous
exogenous
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 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
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 If the economy were
closed…
r S

…the
interest
rate would
adjust to rc
equate
investmen I (r )
t
and S, I
saving:
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 If the economy is open

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 Quick Quiz
In a small open economy with perfect
capital mobility, the real interest rate will
always be:

A)above the world real interest rate.

B)below the world real interest rate.
C)equal to the world real interest rate.
 D)equal to the world nominal interest rate.

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 Three experiments
1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment
demand

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 1. Fiscal policy at home

r S 2 S1
An increase in NX2
G or decrease *
in T reduces r
1
saving. NX1

I (r )

I1 S, I
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 2. Fiscal policy abroad
r S1
Expansionar
NX2
y fiscal
policy r2*
NX
abroad
raises the r1* 1

world
interest rate.
Results:
I (r )

S, I

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

net capital
outflows NX
and net
1 I (r )2
exports
fall by the I (r )1
amount I
I1 I2 S, I
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 The nominal exchange
rate
e = nominal
exchange rate,
the relative price country Euro exchange rate
of U.S.A. 1.39305 $/€
domestic Japan 141.503 Yen/€
currency U.K. 0.820318 £/€
in terms of Switzerland 1.21705 CHF/€
foreign currency Norway 8.24154 NOK/€
Poland 4.19876 zlotys/€
(e.g. Yen per
Turkey 2.91685 lira/€
Euro)

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 The real exchange rate
ε = real exchange rate,
the relative price of
the
domestic goods
lowercase
Greek letter in terms of foreign goods
epsilon

ε  e P
P*

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Example 1
one good: Mars bar
price in Tokyo:
P* = 48 Yen To buy a European Mars
price in Frankfurt: bar, someone from
P = €0.60 Japan would have to
nominal exchange rate
pay an amount that
e = 120 Yen/€ could buy 1.5 Japanese
Mars bars.
ε 
e P
P*
120Yen/€ €0.60 72YEN
  1.5
48Yen 48YEN
 How NX depends on ε

ε  home goods become more

expensive relative to foreign
goods
 EX, IM
 NX
The net exports function reflects
this inverse relationship
between NX and ε:
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 The NX curve
ε

so net
When ε is exports
relatively low, will
be high
ε1
home goods
are relatively NX(ε
inexpensive )
0 N
NX(ε1)
X
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 The NX curve
At high enough
ε
values of ε, home
ε2 goods become so
expensive that
we export
less than
we import

NX(ε
0 )
NX(ε2) N
X
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 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

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 How ε is determined

Neither S nor I ε
depend on ε,
so the net
capital outflow
curve is vertical.
ε1
ε adjusts to
equate NX
NX(ε
with net capital )
NX
outflow, S - I. NX 1

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 demand in the foreign exchange
market

demand:
Foreigners need
ε
pounds to buy the
UK’s net exports.

supply:
ε1
The net capital
outflow (S - I ) NX(ε
is the supply of
)
pounds to be invested NX
abroad. NX 1
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 Three experiments
1. Fiscal policy at home

2. Fiscal policy abroad

3. Trade policy to restrict imports

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 1. Fiscal policy at home

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 2. Fiscal policy abroad

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 3. Trade policy to restrict
imports
Results:
ε > 0 ε
(demand increase)
NX = 0
ε2
(supply fixed)
IM < 0
(policy) ε1
EX < 0 NX (ε )2
(rise in ε )
NX (ε )1
NX
NX1
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A fiscal expansion in three
environments
A fiscal expansion causes national saving to fall.
The effects of this depend on the degree of openness:

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 in

NX change small open economy
falls
 The determinants of the
nominal exchange rate
Start with the expression for the
real exchange rate:

• Solve it for the nominal exchange rate:

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 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:

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 The determinants of the
nominal exchange rate

 We can rewrite this equation in terms of

growth rates (see “arithmetic tricks for
working with percentage changes,” Chap 2 ):

• For a given value of ε,

the growth rate of e equals the difference between
foreign and domestic inflation rates.
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 Purchasing Power Parity (PPP)
Definition 1: a doctrine that states
that goods must sell at the same
(currency-adjusted) price in all
countries.
Definition 2: the nominal exchange
rate adjusts to equalize the cost of a
basket of goods across countries.
Reasoning: arbitrage, the law of
one price
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 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.
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 Purchasing Power Parity (PPP)
If e = P*/P,
then

and the NX curve is horizontal:

ε Under PPP,
S -I
changes in (S -
I ) have no
ε =1 NX impact on ε or e.

41 NX
 Does PPP hold in the real
world?
No, for two reasons:
1. International arbitrage not always
possible.
non-traded goods
transportation costs
2. Goods of different countries not perfect
substitutes.
Nonetheless, PPP is a useful theory:
• It’s simple & intuitive
• In the real world, nominal exchange rates
have a tendency toward their PPP values
over the long run.
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