Module – 4: Open economy

The International Flows of Capital and Goods

The key macroeconomic difference between open and closed economies is that, in an
open economy, a country’s spending in any given year need not equal its output of goods and
services.
In an open economy,
 spending need not equal output
 saving need not equal investment
Because, a country can spend more than it produces by borrowing from abroad, or it can spend
less than it produces and lend the difference to foreigners.
The Role of Net Exports
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.
The division of expenditure into these components is expressed in the identity

The sum of the first three terms, is domestic spending on domestic goods and
services. The fourth term, X, is foreign spending on domestic goods and services.
Note in an open economy, 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.
Thus,

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 ). Thus, the national income accounts identity as became

Because spending on imports is included in domestic spending (C + I + G ), and because

goods and services imported from abroad are not part of a country’s output, this equation
subtracts spending on imports. Defining net exports to be exports minus imports (NX = X –
IM ), the identity becomes

This equation states that 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,

This equation shows that 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.
International Capital Flows and the Trade Balance

In an open economy, as in the closed economy, financial markets and goods markets
are closely related. To see the relationship, rewrite the national income accounts identity in
terms of saving and investment. Begin with the identity
Subtract C and G from both sides to obtain

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, we can write the national income accounts
identity as S – I = NX.
This form of the national income accounts identity shows that an economy’s net exports
must always equal the difference between its saving and its investment.
The right hand side, NX, net exports of goods and services (it is also called as trade
balance).
The left-hand side of the identity is the difference between domestic saving and
domestic investment, S – I, which is called net capital outflow. (It’s sometimes called net
foreign investment.) Net capital outflow 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. 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, it is called trade surplus. In this case, country is a net lender in
world financial markets, and its exporting more goods than importing.
If S – I and NX are negative, it is called trade deficit. In this case, country is a net borrowers
in world financial markets, and its importing more goods than we are exporting.
If S – I and NX are exactly zero, it is called balanced trade because the value of imports
equals the value of exports.
Exchange Rate
Exchange rate is the price of one currency in terms of another currency. In other words,
the exchange rate between two countries is the price at which residents of those countries trade
with each other.
 Economists distinguish between two exchange rates: the nominal exchange rate and the
real exchange rate.
Nominal Exchange Rates
Nominal exchange rate is the rate at which a person can trade the currency of one
country for the currency of another. In other words, the nominal exchange rate is the relative
price of the currencies of two countries.
An exchange rate can be expressed in two ways.
Example:
 Rs.70 per dollar.
 This can also be written as 1/ 70 dollar (or 0.01429 dollar) per Rupee.
Definition of appreciation: An increase in the value of a currency as measured by the amount
of foreign currency it can buy.
Definition of depreciation: a decrease in the value of a currency as measured by the amount
of foreign currency it can buy.
The Real Exchange Rate
Real exchange rate is the rate at which a person can trade the goods and services of one
country for the goods and services of another. In other words, 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.
Example:
A bag of American rice sells for $100 and a bag of Indian rice sells for Rs. 14,000. The
nominal exchange rate is Rs.70 per dollar.
The real exchange rate depends on the nominal exchange rate and on the prices of goods in
the two countries measured in the local currencies.

In our example:
(Rs.70 per $1)($100 per bag of American rice)
Real exchange rate = Rs. 14000 per bag of Indian rice
𝑅𝑠.7000 𝑝𝑒𝑟 𝑏𝑎𝑔 𝑜𝑓 𝐴𝑚𝑒𝑟𝑖𝑐𝑎𝑛 𝑟𝑖𝑐𝑒
Real exchange rate = 14,000 𝑝𝑒𝑟 𝑏𝑎𝑔 𝑜𝑓 𝐼𝑛𝑑𝑖𝑎𝑛 𝑅𝑖𝑐𝑒

Real exchange rate = 1/2 (0.5) bag of Indian rice per bag of American rice.
The real exchange rate is a key determinant of how much a country exports and imports.
 When studying an economy as a whole, macroeconomists focus on overall prices
instead of the prices of individual goods and services.
a. Price indexes are used to measure the level of overall prices.
b. Assume that P is the price index for the United States, P* is a price index for prices
abroad, and e is the nominal exchange rate between the U.S. dollar and foreign currencies.

The real exchange rate measures the price of a basket of goods and services available
domestically relative to the price of a basket of goods and services available abroad.
A depreciation in the U.S. real exchange rate means that U.S. goods have become
cheaper relative to foreign goods. U.S. exports will rise, imports will fall, and net exports will
increase.
Likewise, an appreciation in the U.S. real exchange rate means that U.S. goods have
become more expensive relative to foreign goods. U.S. exports will fall, imports will rise, and
net exports will decline.
The Real Exchange Rate and the Trade Balance
If a country’s real exchange rate is low, domestic residents will want to purchase fewer
imported goods because they find domestic goods are relatively cheaper than imported ones.
Similarly, foreigners will also 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.
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 NX = NX (e). This
equation states that net exports are a function of the real exchange rate.
The following figure illustrates the negative relationship between the trade balance and the real
exchange rate.
 Mundell-Fleming Model
The basic Mundell-Fleming model — like the IS-LM model — is based on the
assumption of fixed price level and shows the interaction between the goods market and the
money market.
The model explains the causes of short-run fluctuations in aggregate income (or,
what comes to the same thing, shifts in the ad curve) in a small open economy.
The Mundell-Fleming model is based on a very restrictive assumption. It considers a
small open economy with perfect capital mobility.
This means that the economy can borrow or lend freely from the international
capital markets at the prevailing rate of interest since its domestic rate of interest is
determined by the world rate of interest. So, the rate of interest is not a policy variable in
the small economy analysis.
This means that macroeconomic adjustment occurs only through exchange rate
changes. The central bank permits the exchange rate to move up or down in response to
changing economic conditions.
The basic assumption of this model is that the domestic rate of interest (r) is equal to
the world rate of interest (r*) in a small open economy with perfect capital mobility. No
doubt any change within the domestic economy may alter the domestic rate of interest, but the
rate of interest cannot stay out of line with the world rate of interest for long. The difference
between the two, if any, is removed quickly through inflows and outflows of financial capital.
It may be recalled that “smallness” of a country has no relation to its size. A small
country is one which cannot alter the world rate of interest through its own borrowing and
lending activities. In contrast, a large economy is one which has market (bargaining) power so
that it can exert influence over the world rate of interest.
 For such a country, either international capital mobility is far from perfect, or the
country is so large that it can exert influence on world capital markets.
The main prediction from the Mundell-Fleming model is that the behaviour of an
economy depends crucially on the exchange rate system it adopts, i.e., whether it operates
a floating exchange rate system or a fixed exchange rate system. We start with adjustment
under a floating exchange rate system, in which case there is no central bank intervention in
the foreign exchange market
In such a situation, if the domestic interest rate goes above the world rate, foreigners
will start lending to the home country. This capital inflow will create excess supply of funds
and the domestic rate of interest r again will fall to r*.
The converse is also true. If, for some reason, the domestic rate of interest (r) falls below
r*, there will be capital outflow from the home country and the resulting shortage of funds will
push up r to the level of r*. Thus, in a world of perfect capital mobility, r will quickly get
adjusted to r*.
The Open Economy IS Curve:
In the Mundell-Fleming model, the market for goods and services is expressed by the
following equation:
Y = C(Y – T) + I(r*) + G + NX(e) … (1)
where all the terms have their usual meanings. Here investment depends on the world rate of
interest r* since r = r* and NX depends on the exchange rate e which is the price of a foreign
currency in terms of domestic currency.
In the Mundell-Fleming model, it is assumed that the price levels at home and
abroad remain fixed. So, there is no difference between real exchange rate and nominal
exchange rate. We now illustrate the equation of the goods market equilibrium in Fig. 12.1.
 In part (a), an increase in the rate from e0 to e1, lowers net exports from NX(e0) to
NX(e1). As a result, the planned expenditure line E1 shifts downward to E0. Consequently,
income falls from Y1 to Y0.
In part (c), we show the new IS curve, which is the locus of points, indicating alternative
combinations of e and Y which ensure equilibrium in the goods market.
The new IS curve is derived by following this sequence:
e rises → NX falls → Y falls
The Open Economy LM Curve:
The equilibrium condition of the money market in the Mundell-Fleming model is:
M = L(r*, Y) … (2)
since r = r*.
Here the supply of money equals its demand and demand for money varies inversely
with r* and the positively with Y. In this model, M remains exogenously fixed by the central
bank.
The new LM curve, as shown in Fig. 12.2(b), is vertical — since the equation (2) has
no relation to the exchange rate. This equation determines only Y, whether e is high or low. In
Fig. 12.2(a), we draw the closed economy LM curve as also a horizontal line showing parity
between r and r*.
The intersection of the two curves at the point A determines the equilibrium level of
income Y0, which has no relation to e, shown on the vertical axis of Fig. 12.2(b). This is why
the new (open economy) LM curve is vertical. The LMN curve of Fig. 12.2(b) is derived from
r* and the closed economy LM curve, shown in Fig. 12.2(a).
General Equilibrium:
In the Fig. 12.3, we show the general equilibrium of goods market and the money
market. The equilibrium income (Y0) and exchange rate (e0) are determined simultaneously at
point A where the IS and LM curves intersect.
Main Message of Mundell-Flemming Model:
The main message of the Mundell-Fleming model is that the effect of any economic
policy (fiscal, monetary or trade) depends on the exchange rate system of the country under
consideration, i.e., whether the country is following a fixed or a floating exchange rate system.
The following table summarises the effects of three different policies in the Mundell-
Fleming model.
Table: The Effects of Three Types of Policies in the Mundell-Fleming Model

The Mundell-Fleming model shows how to make appropriate use of monetary, fiscal
and trade policies to achieve any desired macroeconomic objective. The influence of these
policies depends on the exchange rate system. Under floating exchange rate system, only
monetary policy can alter national income.
The effect of expansionary fiscal policy is totally neutralised by currency appreciation.
Under fixed exchange rate system, only fiscal policy can alter Y. The central bank loses control
over money supply since it has to be adjusted upward or downward for maintaining the
exchange rate at a predetermined level.