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C H A P T E
R
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 =Cd +I d
+ G d + EX
= ( C − C ) + ( I − I ) + ( G − G ) + EX
f f f
= C + I + G + EX − ( C f + I f
+Gf )
= C + I + G + EX − I M
= C + I + G + NX
Y = C + I + G + NX
or, NX = Y – (C + I + G )
domestic
spending
net exports
output
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
0 0%
billions of dollars
percent of GDP
-200 -2%
-400 -4%
-600 -6%
-800 -8%
1950 1960 1970 1980 1990 2000
NX ($ billions) NX (% of GDP)
International capital 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 deficit ((NX
trade deficit NX << 0)
0)
is
is aa net borrower ((SS <<II ).).
net borrower
CHAPTER 5 The Open Economy slide 11
“The world’s largest debtor nation”
r S = Y − C (Y −T ) − G
As
As in in Chapter
Chapter 3,3,
national
national saving
saving does
does
not
not depend
depend on on the
the
interest
interest rate
rate
S S, I
CHAPTER 5 The Open Economy slide 14
Assumptions re: Capital flows
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 (r c ) 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:
NX 1
Results:
∆I = 0
∆NX = ∆S < 0 I (r )
I1 S, I
4%
0%
2%
-2%
0%
Results:
Results:
∆I < 0 I (r )
∆NX = −∆I > 0
S, I
I (r )
2
*
I ( r 1* )
r *
EXERCISE:
EXERCISE:
Use
Use the
the model
model to to NX 1
determine
determine the the impact
impact
of
of an
an increase
increase in in
investment I (r )1
investment demand
demand
on
on NX, S, II,, and
NX, S, and
net I1 S, I
net capital
capital outflow.
outflow.
∆∆SS == 0,0,
net
net capital
capital NX 1
outflow
outflow andand I (r )2
NX
NX fall
fall by
by the
the
amount ∆∆II
amount I (r )1
I1 I2 S, I
⇒ ↓EX, ↑IM
⇒ ↓NX
-1%
80
-2%
60
-3%
-4% 40
Net exports
-5% (left scale)
20
-6%
-7% 0
1973 1977 1981 1985 1989 1993 1997 2001 2005
CHAPTER 5 The Open Economy slide 32
The net exports function
NX = NX(ε )
so U.S. net
When ε is exports will
relatively low, be high
U.S. goods are
relatively ε1
inexpensive
NX (ε )
0
NX (ε 1 ) 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 (ε )
NX(ε 2) 0 N
X
CHAPTER 5 The Open Economy slide 35
How ε is determined
Neither S
Neither nor II
S nor S 1 − I (r * )
ε
depend
depend on on εε,,
so
so the
the net
net capital
capital
outflow
outflow curve
curve isis
vertical.
vertical.
ε1
εε adjusts
adjusts toto
equate
equate NXNX NX (ε )
with
with net
net capital
capital
NX
outflow, S
outflow, S −− II.. NX 1
supply:
supply: ε1
Net
Net capital
capital
outflow ((S
outflow S −− II )) NX (ε )
is
is the
the supply
supply ofof NX
dollars
dollars to
to be
be NX 1
invested
invested abroad.
abroad.
CHAPTER 5 The Open Economy slide 38
Next, four experiments:
A S 2 − I (r * )
A fiscal
fiscal expansion
expansion
reduces
reduces national
national ε S 1 − 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* S 1 − I (r 1 * )
reduces
reduces ε S 1 − I (r 2 * )
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
NX
real
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
εε,, an ε S −I
an import
import quota
quota
⇒⇒ ↓IM
↓IM ⇒ ⇒ ↑NX
↑NX
⇒⇒ demand
demand forfor 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
NX 1
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
∆∆εε >> 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
(rise in εε ))
(rise in
NX
NX 1
P*
eε = ×
P
∆eε ∆P ∆ P* ∆ ∆ε
= + − = + π* − π
eε 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
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.
Impact of policies on NX :
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 goods
The real exchange rate equals the nominal rate
times the ratio of prices of the two countries.