Aggregate Demand in the Open


Economy
International flows of Capital and Goods
Saving and Investment in the Small Open Economy
Exchange rates
The Mundell-Fleming model
Fiscal and monetary policies in an open economy with
perfect capital mobility
o Fixed exchange rate
o Floating exchange rate
Limitations of the Mundell-Fleming model

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 3.1 The International flow of Capital and Goods
 The key difference between open and closed economies is
In an open economy,
 spending need not equal output , saving need not equal investment
 A country can spend more than it produces by borrowing from
abroad, or
 Can spend less than it produces and lend the difference to foreigners.
In an open economy GDP differs from that of a closed economy
because
 There is an export expenditure which is foreign expenditure on
domestically produced goods.
 There is also an expenditure on imports which is domestic
expenditure on foreign goods.
 The identity for an open economy is given by:
Y=C+I+G+X–M
where Y is national income, C is domestic consumption, I is domestic
investment, G is government expenditure, X is export expenditure and
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 Conti….
 The key difference between open and closed economies is
In an open economy,
 spending need not equal output , saving need not equal investment
 A country can spend more than it produces by borrowing from abroad,
or
 Can spend less than it produces and lend the difference to foreigners.
In an open economy GDP differs from that of a closed economy because
 There is an export expenditure which is foreign expenditure on
domestically produced goods.
 There is also an expenditure on imports which is domestic expenditure
on foreign goods.
 The identity for an open economy is given by:
Y=C+I+G+X–M
where Y is national income, C is domestic consumption, I is domestic
investment, G is government expenditure, X is export expenditure and M
is import expenditure.
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 The Role of Net Export
 Consider the expenditure on an economy’s output of G & S.
 In a closed economy, all output is sold domestically, and
expenditure is divided into three components:
 consumption, investment, and government purchases.
 In an open economy, some output is sold domestically
and some is exported to be sold abroad.
We can divide expenditure on an open economy’s output
Y into four components:
Cd = Consumption of domestic goods and services,
Id = Investment in domestic goods and services,
Gd = Government purchases of domestic goods and services,
X = Exports of domestic goods and services.

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 The division of expenditure into these components is expressed as,
Y = Cd + Id + Gd + X
 The first three terms, Cd + Id + Gd is domestic spending on domestic g & s
 The fourth term, X, is foreign spending on domestic goods and services.
 Note that domestic spending on all goods and services equals
 Domestic spending on domestic goods and services plus domestic
spending on foreign goods and services
 Hence, total consumption C equals consumption of domestic goods and
services Cd plus consumption of foreign goods and services Cf;
 Total investment I equals investment in domestic goods and services Id plus
investment in foreign goods and services If ; and
 Total government purchases G equals government purchases of domestic
goods and services Gd plus government purchases of foreign goods and
services Gf.

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 Y = C + I + G + NX.
 Expenditure on domestic output is the sum of consumption,
investment, government purchases, and net exports
 The national income accounts identity shows how domestic
output, domestic spending, and net exports are related.
 In particular Net Exports,
NX = Y − (C + I + G)
Net Exports = Output − Domestic Spending
In an open economy, domestic spending need not equal the
output of goods and services.
 If output exceeds domestic spending, we export the difference:
net exports are positive.
 If output falls short of domestic spending, we import the
difference: net exports are negative.
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 Thus, C= Cd+ Cf , I = Id + If , G= Gd + Gf
We substitute these three equations into the identity above:

We can rearrange to obtain

 The sum of domestic spending on foreign goods and services

( Cf + If + Gf ) is expenditure on imports (IM ).
 We can thus write the national income accounts identity as
Y = C + I + G + X − IM.
 Defining net exports to be exports minus imports (NX = X − IM ),
 The identity becomes Y = C + I + G + NX.
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 International flow of capital and trade balance

 In an open economy, as in the closed economy financial markets and

goods markets are closely related.
 To see the relationship, we must rewrite the NI accounts in terms of
saving and investment.
Y = C + I + G + NX.
 Subtract C and G from both sides to obtain
Y − C − G = I + NX.
 Recall that Y − C − G is national saving S, which equals the sum of
private saving, Y − T − C, and public saving, T − G, where T stands
for taxes.
 Therefore, S = I + NX.
 Subtracting I from both sides of the equation S − I = NX.
 An economy’s net exports must always equal the difference between its
saving and its investment.
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 Right-hand side, NX, the net export of goods and services.
 Another name for net exports is the trade balance, because it
tells us how our trade in goods and services departs from the
benchmark of equal imports and exports.
 The left-hand side: is the difference between domestic saving
and domestic investment, S − I, which we’ll call net capital
outflow. (sometimes called net foreign investment.)
Net capital outflow:-is equals the amount that domestic residents
are lending abroad minus the amount that foreigners are lending
to us.
 If net capital outflow is positive, the economy’s saving exceeds its
investment, and it is lending the excess to foreigners
 If the net capital outflow is negative, the economy is experiencing
a capital inflow: investment exceeds saving, and the economy is
financing this extra investment by borrowing from abroad.
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 Thus, net capital outflow reflects the international flow of funds to
finance capital accumulation.
 The national income accounts identity shows that net capital outflow
always equals the trade balance.
 That is,
Net Capital Outflow = Trade Balance
S − I = NX.
 If S − I and NX are positive, we have a trade surplus.
 In this case, we are 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.
 In this case,we are net borrowers in world financial markets, and we are
importing more goods than we are exporting.
 If S − I and NX are exactly zero, we are said to have balanced trade
because the value of imports equals the value of exports.
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 If domestic saving exceeds domestic investment, the surplus
saving is used to make loans to foreigners.
 Foreigners require these loans because we are providing them
with more goods and services than they are providing us. That
is, we are running a trade surplus
 If investment exceeds saving, the extra investment must be
financed by borrowing from abroad.
These foreign loans enable us to import more goods
and services than we export. That is, we are running a
trade deficit.
 when we run a trade deficit, foreigners make loans to us.

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 4.2 Saving and Investment in the small open Economy
 In international flows of goods and capital, we
have rearranged accounting identities.
 That is, we have defined some of the variables
that measure transactions in an open economy,
and
 we have shown the links among these variables
that follow from their definitions.
 Our next step is to develop a model that
explains the behavior of these variables.
 We can then use the model to answer questions
such as how the trade balance responds to
changes in policy.
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 Capital Mobility and the world interest rate
 In a moment we present a model of the international flows of
capital and goods.
 Because the trade balance equals the net capital outflow, which
in turn equals saving minus investment, our model focuses on
saving and investment.
 To develop this model, we use some elements that should be
familiar from Chapter 3,
 but in contrast to the Chapter 3 model, we do not assume that
the real interest rate equilibrates saving and investment.
 Instead, we allow the economy to run a trade deficit and
borrow from other countries or to run a trade surplus and lend
to other countries.

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 If the real interest rate does not adjust to equilibrate saving and
investment in this model, what does determine the real interest rate?
 We answer this question here by considering the simple case of a
small open economy with perfect capital mobility.
 By “small’’ we mean that this economy is a small part of the world
market and thus, by itself, can have only a negligible effect on the
world interest rate.
 By “perfect capital mobility’’ we mean that residents of the country
have full access to world financial markets.
 In particular, the government does not impede international
borrowing or lending.
 Because of this assumption of perfect capital mobility, the interest
rate in our small open economy, r, must equal the world interest rate
r*, the real interest rate prevailing in world financial markets:
r = r *.
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 Residents of the small open economy need never borrow at any interest
rate above r*, because they can always get a loan at r* from abroad.
 Similarly, residents of this economy need never lend at any interest rate
below r* because they can always earn r* by lending abroad.
 Thus, the world interest rate determines the interest rate in our small
open economy
 Let’s discuss briefly what determines the world real interest rate.
 In a closed economy, the equilibrium of domestic saving and domestic
investment determines the interest rate.
 Therefore, the equilibrium of world saving and world
investment determines the world interest rate
 Our small open economy has a negligible effect on the world real interest
rate because, being a small part of the world, it has a negligible effect on
world saving and world investment.
 Hence, our small open economy takes the world interest rate as
exogenously given.
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 The Model
 To build the model of the small open economy, we take three
assumptions from
 The economy’s output Y is fixed by the factors of production and
the production function. We write this as

 Consumption C is positively related to disposable income Y −

T.
 We write the consumption function as C = C(Y − T ).
 Investment I is negatively related to the real interest rate r.
 We write the investment function as I = I(r).
 We can now return to the accounting identity and write it as
NX = (Y − C − G) − I
NX = S − I.
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 Substituting the assumptions above and the assumption that
the interest rate equals the world interest rate, we obtain

 This equation shows that the trade balance NX depends on

those variables that determine saving S and investment I.
 Because saving depends on fiscal policy (lower government
purchases G or higher taxes T raise national saving) and
 investment depends on the world real interest rate r* (a
higher interest rate makes some investment projects
unprofitable), the trade balance depends on these variables
as well.

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 In the closed economy, the real interest rate adjusts to equilibrate saving
and investment—that is, the real interest rate is found where the saving and
investment curves cross.
 In the small open economy, however, the real interest rate equals the world
real interest rate.
 The trade balance is determined by the difference between saving and
investment at the world interest rate.
 At this point, you might wonder about the mechanism that causes the
trade balance to equal the net capital outflow.
 The determinants of the capital flows are easy to understand.
 When saving falls short of investment, investors borrow from abroad;
 when saving exceeds investment, the excess is lent to other countries.
 But what causes those who import and export to behave so as to ensure that
the international flow of goods exactly balances this international flow of
capital? For now we leave this question unanswered, but we return to it in
Section 4-3 when we discuss the determination of exchange rates.

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 How polices influence trade balance?
 Suppose that the economy begins in a position of balanced trade. That is,
at the world interest rate, investment I equals saving S, and net exports
NX equal zero.
 Let’s use our model to predict the effects of government policies at home
and abroad.
Fiscal Policy at Home :
 Consider first what happens to the small open economy if the
government expands domestic spending by increasing government
purchases.
 The increase in G reduces national saving, because S = Y − C − G. With
an unchanged world real interest rate, investment remains the same.
 Therefore, saving falls below investment, and some investment must
now be financed by borrowing from abroad.
 Because NX = S − I, the fall in S implies a fall in NX. The economy now
runs a trade deficit.
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 A tax cut lowers T, raises disposable income Y − T, stimulates
consumption, and reduces national saving. (Even though some
of the tax cut finds its way into private saving, public saving
falls by the full amount of the tax cut; in total, saving falls.)
 Because NX = S − I, the reduction in national saving in turn
lowers NX.
 A fiscal policy change that increases private consumption C or
public consumption G reduces national saving (Y − C − G) and,
therefore, shifts the vertical line that represents saving from S1
to S2. Because
 NX is the distance between the saving schedule and the
investment schedule at the world interest rate, this shift reduces
NX.
 Hence, starting from balanced trade, a change in fiscal policy
that reduces national saving leads to a trade deficit.
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 Fiscal Policy Abroad :
 what happens to a small open economy when foreign governments
increase their government purchases.
 If these foreign countries are a small part of the world economy,
then their fiscal change has a negligible impact on other
countries.
 But if these foreign countries are a large part of the world
economy, their increase in government purchases reduces world
saving.
 The decrease in world saving causes the world interest rate to rise
 The increase in the world interest rate raises the cost of borrowing
and, thus, reduces investment in our small open economy.
 Because there has been no change in domestic saving, saving S
now exceeds investment I, and some of our saving begins to flow
abroad.
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 Because NX = S − I, the reduction in I must also increase NX.
Hence, reduced saving abroad leads to a trade surplus at home.
 Figure 4-3 below illustrates how a small open economy starting
from balanced trade responds to a foreign fiscal expansion.
 Because the policy change is occurring abroad, the domestic
saving and investment schedules remain the same. The only
change is an increase in the world interest rate from r1 * to r2 *.
 The trade balance is the difference between the saving and
investment schedules; because saving exceeds investment at r2 *,
there is a trade surplus.
 Hence, starting from balanced trade, an increase in the world
interest rate due to a fiscal expansion abroad leads to a trade
surplus

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 Shifts in Investment Demand:
 Consider what happens to our small open economy if its
investment schedule shifts outward—that is, if the demand
for investment goods at every interest rate increases.
 This shift would occur if, for example, the government
changed the tax laws to encourage investment by
providing an investment tax credit. Figure 4-4 below
illustrates the impact of a shift in the investment schedule.
 At a given world interest rate, investment is now higher.
Because saving is unchanged, some investment must now
be financed by borrowing from abroad. Because capital
flows into the economy to finance the increased
investment, the net capital outflow is negative.
 Put differently, because NX = S − I, the increase in I
implies a decrease in NX.
 Hence, starting from balanced trade, an outward shift in
the investment schedule causes a trade deficit
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 4.3 Exchange Rate
 Having examined the international flows of capital and of
goods and services, we now extend the analysis by considering
the prices that apply to these transactions.
 The exchange rate between two countries is the price at which
residents of those countries trade with each other.
 In this section we first examine precisely what the exchange
rate measures, and we then discuss how exchange rates are
determined.

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 Nominal and Real Exchange Rates
 Economists distinguish between two exchange rates: the
nominal exchange rate and the real exchange rate
 The nominal exchange rate is the relative price of the
currencies of two countries.
 Example, if the exchange rate b/n the U.S. dollar and the
Japanese yen is 120 yen per dollar, then you can exchange one
dollar for 120 yen in world markets for foreign currency.
 A Japanese who wants to obtain dollars would pay 120 yen
for each dollar he bought
 An American who wants to obtain yen would get 120 yen for
each dollar he paid.
 When people refer to “the exchange rate’’ between two
countries, they usually mean the nominal exchange rate.
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 Notice that an exchange rate can be reported in two ways.
 If one dollar buys 120 yen, then one yen buys 0.00833 dollar.
 We can say the exchange rate is 120 yen per dollar, or we
can say the exchange rate is 0.00833 dollar per yen.
 These two ways of expressing the exchange rate are
equivalent.
 A rise in the exchange rate—say, from 120 to 125 yen per
dollar—is called an appreciation of the dollar;
 A fall in the exchange rate is called a depreciation.
 When the domestic currency appreciates, it buys more of the
foreign currency; when it depreciates, it buys less.
 An appreciation is sometimes called a strengthening of the
currency, and a depreciation is sometimes called a
weakening of the currency.
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 The Real Exchange Rate
 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.
 The real exchange rate is sometimes called the terms of trade.
 To see the relation between the real and nominal exchange rates, consider a
single good produced in many countries: cars.
o Suppose an American car costs $10,000 and a similar Japanese car costs
2,400,000 yen.
 To compare the prices of the two cars, we must convert them into a
common currency.
 If a dollar is worth 120 yen, then the American car 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), we conclude that the American car costs
one-half of what the Japanese car costs.
 In other words, at current prices, we can exchange 2 American cars for 1
Japanese car.
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 This calculation of the real exchange rate for a single good
suggests how we should define the real exchange rate for a
broader basket of goods.
 Let e be the nominal exchange rate (the number of yen per
dollar), P be the price level in the United States (measured in
dollars), and P* be the price level in Japan (measured in yen).
 Then the real exchange rate e is

 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 goods are relatively cheap.
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 The Real Exchange Rate and the Trade Balance
What macroeconomic influence does the real exchange
rate exert? To answer this question, remember that the
real exchange rate is nothing more than a relative price.
Just as the relative price of hamburgers and pizza
determines which you choose for lunch, the relative price
of domestic and foreign goods affects the demand for
these goods
Suppose first that the real exchange rate is low. In this
case, because domestic goods are relatively cheap,
domestic residents will want to purchase fewer imported
goods: they will buy Fords rather than Toyotas, drink Coors
rather than Heineken, and vacation in Florida rather than
Italy.
 For the same reason, foreigners will want to buy many of
our goods. As a result of both of these actions, the
quantity of our net exports demanded will be high.
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 The opposite occurs if the real exchange rate is high.
Because domestic goods are expensive relative to
foreign goods, domestic residents will want to buy many
imported goods, and foreigners will want to buy few of
our goods.
Therefore, the quantity of our net exports demanded
will be low.
We write this relationship between the real exchange
rate and net exports as

This equation states that net exports are a function of

the real exchange rate. Figure 5-7 illustrates the
negative relationship between the trade balance and
the real exchange rate.
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 The Determinants of the Real Exchange Rate
We now have all the pieces needed to construct a model
that explains what factors determine the real exchange
rate.
In particular, we combine the relationship between net
exports and the real exchange rate we just discussed
with the model of the trade balance we developed
earlier in the chapter.
We can summarize the analysis as follows:
 The real exchange rate is related to net exports. When the
real exchange rate is lower, domestic goods are less
expensive relative to foreign goods, and net exports are
greater.
 The trade balance (net exports) must equal the net capital
outflow, which in turn equals saving minus investment.
Saving is fixed by the consumption function and fiscal
policy; investment is fixed by the investment function and
the world interest rate.
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 The Mundell–Fleming model is a close relative of the IS–LM model.
4.4 The Mundell–Fleming Model

 Both models
 stress the interaction between the goods market and the money
market.
 assume that the price level is fixed
 The key difference is that
 IS–LM model assumes a closed economy
 Mundell–Fleming model assumes an open economy.
 Mundell–Fleming model extends the short-run model of national
income by including the effects of international trade and finance.
 The Mundell–Fleming model makes one important and extreme
assumption:
 The economy being studied is a small open economy with perfect
capital mobility.
That is, the economy can borrow or lend as much as it wants in world
financial markets and, as a result, r = r*
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 One lesson from the Mundell–Fleming model is that the
behavior of an economy depends on the exchange-rate
system it has adopted.
 We begin by assuming that the economy operates with a
floating exchange rate.
 That is, we assume that the central bank allows the
exchange rate to adjust to changing economic conditions.
 We then examine how the economy operates under a fixed
exchange rate.
 After developing the model, we will be in a position to
address an important policy question: what exchange-rate
system should a nation adopt?

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 Curve
 The Mundell–Fleming model describes the market for goods and services
Y = C(Y – T) + I(r) + G + NX(e).
 Y aggregate income is the sum of consumption C, investment I, government
purchases G, and net exports NX.
 Consumption depends positively on disposable income Y-T.
 Investment depends negatively on the interest rate.
 Net exports depend negatively on the exchange rate e.
 The exchange rate e as the amount of foreign currency per unit of domestic
currency
 You may recall that in section 4.3 we related net exports to the real exchange rate
rather than the nominal exchange rate
 If e is the nominal exchange rate, then the real exchange rate є equals eP/P*,
 where P is the domestic price level and P* is the foreign price level.
 The Mundell–Fleming model, however, assumes that the price levels at home
and abroad are fixed,
 so the real exchange rate is proportional to the nominal exchange rate
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The goods-market equilibrium condition has
two financial variables affecting expenditure on
goods and services
 the interest rate and the exchange rate),
 but the situation can be simplified using the
assumption of perfect capital mobility, so r = r*.
Y = C(Y -T ) + I(r*) + G + NX(e). this the
IS* equation.
 (The asterisk reminds us that interest rate
constant at the world interest rate r*.)
 We can illustrate this equation on a graph in
which income is on the horizontal axis and the
exchange rate is on the vertical axis. This curve
is shown in panel (c) of Figure 4.12
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  The IS* curve slopes downward because a
higher exchange rate reduces net exports,
which in turn lowers aggregate income.
 To show how this works, the other panels of
Figure 4.12 combine the net-exports schedule
and the Keynesian cross to derive the IS*
curve.
 In panel (a), an increase in the exchange rate
from e1 to e2 lowers net exports from NX(e1)
to NX(e2).
 In panel (b), the reduction in net exports shifts
the planned-expenditure schedule downward
and thus lowers income from Y1 to Y2.
 The IS* curve summarizes this relationship
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between the exchange rate e and income Y.
 •

 The Mundell–Fleming model represents the money

The Money Market and the LM* Curve

market
M/P = L(r, Y).
 This equation states that the supply of real money
balances M/P equals the demand L(r, Y ).
 The demand for real balances depends negatively on
the interest rate and positively on income Y.
 The money supply M is an exogenous variable
controlled by the central bank, and price level P is
also fixed(SR model).
Once again, we add the assumption r = r*:
M/P = L(r*, Y ). this the LM* equation.
 The LM* curve is vertical because the exchange rate
does not enter into the LM* equation

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According to the Mundell–Fleming model, a small open
economy with perfect capital mobility can be described by
two equations:
Y = C(Y -T ) + I(r*) + G + NX(e) IS*,
M/P = L(r*, Y) LM*.
 The first equation describes equilibrium in the goods market;
the second describes equilibrium in the money market.
 The exogenous variables are fiscal policy G and T, monetary
policy M, the price level P, and the world interest rate r*.
 The endogenous variables are income Y and the exchange
rate e.
 The equilibrium is found where the IS* curve and the LM*
curve intersect.
 This intersection shows the exchange rate and the level of
income at which the goods market and the money market
are both in equilibrium

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