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Imports and exports (% of GDP), 2007

Chapter 5: Open Economy 45%

40%
Imports
Exports
35%

30%

25%

20%

15%

10%

5%

0%
CHAPTER 1 The Science of Macroeconomics 0 Canada France Germany Italy Japan U.K. U.S.

In an open economy, Preliminaries

superscripts:
 spending need not equal output C C d C f d = spending on
domestic goods
 saving need not equal investment I Id If f = spending on
G G d G 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 2 CHAPTER 5 The Open Economy 3

GDP = expenditure on The national income identity

domestically produced g & s in an open economy

Y  C d  I d  G d  EX Y = C + I + G + NX
f f f
 (C  C )  (I  I )  (G  G )  EX
or, NX = Y – (C + I + G )
 C  I  G  EX  (C f  I f  G f )
domestic
 C  I  G  EX  IM spending
net exports
 C  I  G  NX output

CHAPTER 5 The Open Economy 4 CHAPTER 5 The Open Economy 5

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Trade surpluses and deficits International capital flows

NX = EX – IM = Y – (C + I + G )  Net capital outflow

=S –I
 trade surplus: = net outflow of “loanable funds”
output > spending and exports > imports
Si off the
Size th ttrade l = NX
d surplus = net purchases of foreign assets
the country’s purchases of foreign assets
 trade deficit: minus foreign purchases of domestic assets
spending > output and imports > exports
Size of the trade deficit = –NX  When S > I, country is a net lender
 When S < I, country is a net borrower
CHAPTER 5 The Open Economy 6 CHAPTER 5 The Open Economy 7

Saving, investment, and the trade balance

The link between trade & cap. flows (percent of GDP) 1960-2007
24% 8%
NX = Y – (C + I + G ) 22% investment
6%
implies 20%

NX = (Y – C – G ) – I 18%
4%

= S – I 16% 2%
saving
trade balance = net capital outflow 14% 0%

12%
Thus, -2%

a country with a trade deficit (NX < 0)

10%
trade balance -4%
is a net borrower (S < I ). 8%
(right scale)
6% -6%
CHAPTER 5 The Open Economy 8 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

U.S.: “The world’s largest debtor nation” Saving and investment in a

small open economy
 Every year since 1980s: huge trade deficits and
net capital inflows, i.e. net borrowing from abroad  An open-economy version of the loanable
funds model from Chapter 3.
 As of 12/31/2008:
 U.S. residents owned $19.9 trillion worth of  Includes many of the same elements:
f i assets
foreign t  production function Y  Y  F (K , L )
 Foreigners owned $23.4 trillion worth of
U.S. assets
 consumption function C  C (Y  T )
 U.S. net indebtedness to rest of the world:  investment function I  I (r )
$3.5 trillion--higher than any other country,
 exogenous policy variables G  G , T  T
hence U.S. is the “world’s largest debtor nation”
CHAPTER 5 The Open Economy 10 CHAPTER 5 The Open Economy 11

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National saving: Assumptions about capital flows

The supply of loanable funds
r a. domestic & foreign bonds are perfect substitutes
S  Y  C (Y  T )  G
(same risk, maturity, etc.)
b. perfect capital mobility:
As in Chapter 3,
national saving g does no restrictions on international trade in assets
not depend on the c. economy is small:
interest rate cannot affect the world interest rate, denoted r*

a & b imply r = r*
S S, I c implies r* is exogenous
CHAPTER 5 The Open Economy 12 CHAPTER 5 The Open Economy 13

Investment: If the economy were closed…

The demand for loanable funds
r S
r Investment is still a
…the interest
downward-sloping function
rate would
of the interest rate,
adjust to
but the exogenous equate
world
ld iinterest
t t rate…
t investment
r* rc
…determines the and saving:
country’s level of
investment. I (r )
I (r )
I (rc ) S, I
I (r* ) S, I
S
CHAPTER 5 The Open Economy 14 CHAPTER 5 The Open Economy 15

But in a small open economy… Next, three experiments:

r 1. Fiscal policy at home
the exogenous S
world interest 2. Fiscal policy abroad
rate determines
investment… NX
3. An increase in investment demand
r*
(exercise)
…and the
difference rc
between saving
and investment I (r )
determines net
capital outflow I1 S, I
and net exports
CHAPTER 5 The Open Economy 16 CHAPTER 5 The Open Economy 17

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NX and the federal budget deficit

1. Fiscal policy at home (% of GDP), 1965-2009
r S 2 S1
8%
Budget deficit
An increase in G 2%
6% (left scale)
or decrease in T NX2
reduces saving. r1* 4% 0%
NX1
Results: 2%
-2%
I  0
NX  S  0 I (r ) 0%

-4%
I1 S, I -2% Net exports
(right scale)
-4% -6%
CHAPTER 5 The Open Economy 18 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

NOW YOU TRY:

2. Fiscal policy abroad
3. An increase in investment demand
r S1
r
Expansionary Use the S
NX2
fiscal policy model to
abroad raises r2* determine r*
the world
NX1
the impact of
interest rate. r1* an increase
NX1
in investment
Results: demand on
I  0 I (r ) NX, S, I, and I (r )1
net capital
NX  I  0
S, I outflow. I1 S, I
I (r2* ) I (r1* )

CHAPTER 5 The Open Economy 20

ANSWERS:
The nominal exchange rate
3. An increase in investment demand
r
S
I > 0, NX2
S = 0, e = nominal exchange rate,
r*
net capital the relative price of
outflow and domestic currency
NX fall NX1 in terms of foreign currency
by the I (r )2
amount I (e.g. Yen per Dollar)
I (r )1

I1 I2 S, I

CHAPTER 5 The Open Economy 23

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A few exchange rates, as of 6/24/2009 The real exchange rate

country exchange rate

Euro area 0.72 Euro/$ ε = real exchange rate,
Indonesia 10,337 Rupiahs/$
the relative price of
the lowercase domestic goods
Japan 95 9 Yen/$
95.9 G k lletter
Greek in terms of foreign goods
Mexico 13.3 Pesos/$ epsilon
(e.g. Japanese Big Macs per
Russia 31.4 Rubles/$ U.S. Big Mac)
South Africa 8.1 Rand/$
U.K. 0.61 Pounds/$

CHAPTER 5 The Open Economy 25

Understanding the units of ε ~ McZample ~

e P  one good: Big Mac
ε 
P *  price in Japan:
(Yen per $)  ($ per unit U.S. goods) P* = 200 Yen
  price in USA:
Yen per unit Japanese goods
P = $2.50
Yen per unit U.S. goods  nominal exchange rate
 e = 120 Yen/$ To buy a U.S. Big Mac,
Yen per unit Japanese goods
e P someone from Japan
ε  would have to pay an
Units of Japanese goods P *
 amount that could buy
per unit of U.S. goods 120  $2.50
  1 .5 1.5 Japanese Big Macs.
200 Yen
CHAPTER 5 The Open Economy 26 CHAPTER 5 The Open Economy 27

ε in the real world & our model How NX depends on ε

 In the real world:
We can think of ε as the relative price of ε  U.S. goods become more expensive
a basket of domestic goods in terms of a basket relative to foreign goods
of foreign goods
 EX, IM
 In our macro model:
There’s just one good, “output.”  NX
So ε is the relative price of one country’s output
in terms of the other country’s output

CHAPTER 5 The Open Economy 28 CHAPTER 5 The Open Economy 29

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U.S. net exports and the real exchange rate,

1973-2009 The net exports function
4% Trade-weighted real 140
exchange rate index
120  The net exports function reflects this inverse
2%
relationship between NX and ε :

Index (March 1973 = 100)

100
NX (% of GDP)

0%
80
NX = NX(ε )
-2%
60
-4%
40
Net exports
-6% (left scale) 20

-8% 0
1970 1975 1980 1985 1990 1995 2000 2005 2010 CHAPTER 5 The Open Economy 31

The NX curve for the U.S. The NX curve for the U.S.

ε ε At high enough
values of ε,
ε2 U.S. goods become
so U.S. net so expensive that
we export
p
When ε is exports will
relatively low, be high less than
U.S. goods are we import
relatively ε1
inexpensive
NX (ε) NX (ε)
0
NX(ε1) NX NX(ε2) 0 NX
CHAPTER 5 The Open Economy 32 CHAPTER 5 The Open Economy 33

How ε is determined How ε is determined

 The accounting identity says NX = S – I Neither S nor I

ε S 1  I (r *)
depend on ε,
 We saw earlier how S – I is determined: so the net capital
 S depends on domestic factors (output, fiscal outflow curve is
policyy variables, etc)) vertical.
 I is determined by the world interest
ε1
rate r * ε adjusts to
 So, ε must adjust to ensure equate NX NX(ε )
with net capital
outflow, S  I. NX
NX (ε )  S  I (r *) NX 1

CHAPTER 5 The Open Economy 34 CHAPTER 5 The Open Economy 35

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Interpretation: supply and demand

Next, four experiments:
in the foreign exchange market
1. Fiscal policy at home
demand: S 1  I (r *)
ε
Foreigners need 2. Fiscal policy abroad
dollars to buy
U.S. net exports. 3. An increase in investment demand
(exercise)
supply: ε1
4. Trade policy to restrict imports
Net capital
outflow (S  I ) NX(ε )
is the supply of
NX
dollars to be NX 1
invested abroad.
CHAPTER 5 The Open Economy 36 CHAPTER 5 The Open Economy 37

1. Fiscal policy at home 2. Fiscal policy abroad

S 2  I (r *) An increase in r* S 1  I (r1 *)
A fiscal expansion
reduces
reduces national ε S 1  I (r *) ε S 1  I (r 2 * )
investment,
saving, net capital
increasing net
outflow, and the ε2 capital outflow ε1
supply of dollars
and the supply of
in the foreign
ε1 dollars in the ε2
exchange
foreign exchange
market…
NX(ε ) market… NX(ε )
…causing the real
NX …causing the real NX
exchange rate to NX 2 NX 1 NX 1 NX 2
rise and NX to fall. exchange rate to fall
and NX to rise.
CHAPTER 5 The Open Economy 38 CHAPTER 5 The Open Economy 39

NOW YOU TRY: ANSWERS:

3. Increase in investment demand 3. Increase in investment demand
An increase in S1  I 2
Determine the ε S1  I1 investment ε S1  I1
impact of an reduces net
increase in capital outflow ε2
investment and the supply
demand on of dollars in the
net exports, ε1 foreign ε1
net capital exchange
outflow, NX(ε ) market… NX(ε )
and the real NX NX
NX 1 …causing the real NX 2 NX 1
exchange rate
exchange rate to rise
and NX to fall.

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4. Trade policy to restrict imports 4. Trade policy to restrict imports

At any given value of Results:

ε, an import quota ε S I ε S I
ε > 0
 IM  NX (demand
 demand for ε2 increase) ε2
dollars shifts NX = 0
right ε1 (supply fixed) ε1
NX (ε )2 IM < 0 NX (ε )2
Trade policy doesn’t (policy)
NX (ε )1 NX (ε )1
affect S or I , so EX < 0
capital flows and the NX (rise in ε ) NX
NX1 NX1
supply of dollars
remain fixed.
CHAPTER 5 The Open Economy 42 CHAPTER 5 The Open Economy 43

The determinants of the The determinants of the

nominal exchange rate nominal exchange rate
 Start with the expression for the real exchange  So e depends on the real exchange rate and
rate: e P the price levels at home and abroad…
ε 
P* …and we know how each
of them is determined: M*
 L * (r *   *, Y * )
 Solve
S l ffor th
the nominal
i l exchange
h rate:
t P*
P* P*
e  ε  e  ε 
P P
M
 L (r *   ,Y )
NX (ε )  S  I (r *) P

CHAPTER 5 The Open Economy 44 CHAPTER 5 The Open Economy 45

The determinants of the Inflation differentials and nominal exchange

nominal exchange rate rates for a cross section of countries
P* % change 30%
e  ε  Mexico
P in nominal
25%
exchange
 Rewrite this equation in growth rates rate 20%
(see “arithmetic tricks for working with percentage Iceland
changes,” Chap 2 ): 15%
ε
Pakistan
e ε P * P
     *   10%
Australia S. Africa
e ε P* P ε 5% Canada S. Korea
 For a given value of ε, 0%
Singapore
U.K.
the growth rate of e equals the difference Japan
between foreign and domestic inflation rates. -5%
-10% -5% 0% 5% 10% 15% 20% 25% 30%
CHAPTER 5 The Open Economy 46 inflation differential

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Purchasing Power Parity (PPP) Purchasing Power Parity (PPP)

Two definitions:  PPP: e P = P* Cost of a basket of

foreign goods, in
 A doctrine that states that goods must sell at the
foreign currency.
same (currency-adjusted) price in all countries.
 The nominal exchange rate adjusts to equalize Cost of a basket of Cost of a basket of
the
h cost off a basket
b k off goods
d across countries.
i domestic goods
goods, in domestic goods, in
foreign currency. domestic currency.
Reasoning:
 arbitrage, the law of one price  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 48 CHAPTER 5 The Open Economy 49

Purchasing Power Parity (PPP) Does PPP hold in the real world?
 If e = P*/P, No, for two reasons:
P
then ε  e  * 
P* P
 * 1 1. International arbitrage not possible.
P P P  nontraded goods
and the NX curve is horizontal:
 transportation costs
ε 2 Different countries’
2. countries goods not perfect substitutes
substitutes.
S I Under PPP,
changes in
Yet, PPP is a useful theory:
(S – I ) have no
ε =1 NX impact on ε or e.
 It’s simple & intuitive.
 In the real world, nominal exchange rates
tend toward their PPP values over the long run.
NX
CHAPTER 5 The Open Economy 50 CHAPTER 5 The Open Economy 51

CASE STUDY:
The Reagan deficits revisited The U.S. as a large open economy

actual closed small open

 So far, we’ve learned long-run models for
1970s 1980s two extreme cases:
change economy economy
G–T 2.2 3.9   
 closed economy (chap. 3)
 small open economy (chap. 5)
S 19.6 17.4   
 A large open economy – like the U
U.S.
S – falls
r 1.1 6.3   no change between these two extremes.
I 19.9 19.4   no change  The results from large open economy analysis
NX -0.3 -2.0  no change  are a mixture of the results for the
closed & small open economy cases.
ε 115.1 129.4  no change 
Data: decade averages; all except r and ε are expressed as a percent of GDP;  For example…
ε is a trade-weighted index.
CHAPTER 5 The Open Economy 53

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A fiscal expansion in three models Chapter Summary

A fiscal expansion causes national saving to fall.  Net exports--the difference between
The effects of this depend on openness & size:  exports and imports
closed large open small open  a country’s output (Y )
economy economy economy and its spending (C + I + G)

r rises
rises, but not as much no  Net capital outflow equals
as in closed economy change
 purchases of foreign assets
falls, but not as much no minus foreign purchases of the country’s
I falls
as in closed economy change assets
no falls, but not as much as  the difference between saving and investment
NX falls
change in small open economy
CHAPTER 5 The Open Economy 54

Chapter Summary Chapter Summary

 National income accounts identities:
 Y = C + I + G + NX
 trade balance NX = S  I net capital outflow
 Impact
I li i on NX :
t off policies
 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
 Exchange rates
 nominal: the price of a country’s currency in
terms of another country’s currency
 real: the price of a country’s goods in terms
of another country’s
country s goods
 The real exchange rate equals the nominal
rate times the ratio of prices of the two
countries.

Chapter Summary 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
 How the nominal exchange rate is determined
 e equals the real exchange rate times the
country’s price level relative to the foreign
price level.
 For a given value of the real exchange rate,
rate
the percentage change in the nominal
exchange rate equals the difference between
the foreign & domestic inflation rates.

10