Lecture Notes in Intermediate Macroeconomics Economics Dpt, AAU.

CHAPTER FIVE
OPEN ECONOMY MACROECONOMICS

3.1 The Basic Model

a. Open Economy National Income Identity

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. 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.

In an open economy gross domestic product (GDP) differs from that of a closed economy
because there is an additional injection- export expenditure which represents foreign
expenditure on domestically produced goods. There is also an additional leakage,
expenditure on imports which represents domestic expenditure on foreign goods and
which raises foreign national income. The identity for an open economy is given by:

[3.1] 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.

If we deduct taxation from the right-hand side of equation [3.1] we have:

[3.2] Yd = C + I + G + X – M –T

where Yd is disposable income.

If we denote private savings as S = Yd – C we can rearrange equation [3.2] to obtain:

[3.3] (X – M) = (S – I) + (T – G)
Current account balance Net (dis)saving of private sector Government
fiscal deficit/ surplus

Equation [3.3] says that a current account deficit has a counterpart in either private
dissaving- that is private investment exceeding private saving- and/or in a government
deficit- that, government expenditure exceeding government taxation revenue. The
equation is merely an identity and says nothing about causation. Nonetheless, it is often
stated that the current account deficit is due to lack of private savings and/or the
government budget deficit. However, it is possible that the causation runs the other way,
with the current account deficit being responsible for the lack of private savings or budget
deficit.

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b. Income determination in an open economy

In an open economy, the equilibrium level of national income is determined where the
domestic balance is equals to the external balance. The starting point would be equation
[3.1]

Y = C + I + G + X – M; and we would make certain additions to this equation.

Domestic consumption is partly autonomous and partly determined by the level of

national income. This is denoted algebraically by:

[3.4] C =Ca + cY

where Ca is autonomous consumption and c is the marginal propensity to consume, that is

the fraction of any increase in income that is spent on consumption. In this simple model
consumption is assumed to be a linear function of income. An increase in consumers'
income induces an increase in their consumption.

Import expenditure is also assumed to be partly autonomous and partly a positive

function of the level of domestic income:

[3.5] M = Ma + mY

where Ma is autonomous import expenditure and m is the marginal propensity to import,

that is the fraction of any increase in income that is spent on imports. In this simple
formulation import expenditure is assumed to be a positive linear function of income.
There are several justifications for this; on the one hand increased income leads to
increased expenditure on imports, and also more domestic production normally requires
more imports of intermediate goods.

Government expenditure and exports are assumed to be exogenous; government

expenditure being determined independently by political decisions, and exports by
foreign expenditure decisions and foreign income.

Substituting equations [3.4] and [3.5] into equation [3.1] we obtain:

[3.6] Y = Ca + cY + I + G + X - Ma + mY

Rearranging [3.6], we have

Y - Ca + cY + I + G = X - Ma + mY

[3.7] Y – AD(Y) = NX(Y)

where AD is aggregate demand which is equals to Ca + cY + I + G and NX is net export

defined as X - Ma + mY.

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Equation [3.7] tells us that the economy would be in equilibrium where the domestic
balance –i.e. Y – AD is equals to the external balance – i.e. NX. Income (Y) and net
export balance associated with this condition are the equilibrium levels of output and
trade balance. The equilibrium condition stated in equation [3.7] is depicted on the figure
below.

Figure 3.1 Income Determination in an open economy

The above figure shows the equilibrium condition in an open economy. The (Y – AD)
curve is upward sloping since its slope is given by 1- c which is equals to marginal
propensity to save and hence positive; the NX curve is downward sloping with the slope
of –m. That is

d  y  AD( Y )  d  y  Ca  cY  I  G 
 1  c
dy dy
and
d NX ( Y )  d  X  Ma  mY 
  m
dy dy

At the intersection of the two curves the economy would be in equilibrium as the internal
balance is bridged up by the external balance or vice versa. Y* and NX* are the
equilibrium level of national income and trade balance or net export.

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c. Open-Economy Multipliers

John Maynard Keynes in his classic work The General Theory of Employment, Interest
and Money (1936) pioneered the use of multiplier analysis to examine the effects of
changes in government expenditure and investment on output and employment. However,
his work was concerned almost exclusively with a closed economy. It was not long,
however, before the ideas of Keynes' work were applied to an analysis of open
economies, most notably by Fritz Machlup (1943).

The assumptions underlying basic multiplier analysis are:

i. both domestic prices and the exchanger rate are fixed,
ii. the economy is operating at less than full employment so that increases in
demand result in an expansion of output, and
iii. the authorities adjust the money supply to changes in money demand by
pegging the domestic interest rate.

The implication of the last assumption is that increases in output that lead to a rise in
money demand would, with a fixed money supply, lead to a rise in the domestic interest
rate. But it is assumed that the authorities passively expand the money stock to meet any
increase in money demand so that interest rates do not have to change. There is no
inflation resulting from the money supply expansion because it is merely a response to
the increase in money demand.

Rearranging equation [3.6]

Y = Ca + cY + I + G + X - Ma + mY

[3.8] (1- c + m)Y = Ca + I + G + X - Ma

Given that (1- c) is equal to the marginal propensity to save s, that is, the fraction of any
increase in income that is saved, then we obtain:

1
[3.9] Y  Ca  I  G  Ma
sm
Equation {3.9] can be transformed into difference form to yield:

1
[3.10] dY  dCa  dI  dG  dX  dMa
sm
The Government Expenditure Multiplier

The first multiplier of interest is the government expenditure multiplier, which shows the
increase in national income resulting from a given increase in government expenditure.
This is given by:

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dY 1
[3.11]  0
dG s  m 
Equation [3.11] says that an increase in government expenditure will have an
expansionary effect on national income, the size of which depends upon the marginal
propensity to save and the marginal propensity to import. Since the sum of these is less
than unity, an increase in government expenditure will result in an even greater increase
in national income. Furthermore, the value of the open-economy multiplier is less than
the closed-economy multiplier which is given by 1/s. The reason for this is that increased
expenditure is spent on both domestic and foreign goods rather than domestic goods
alone, and the expenditure on foreign goods raises foreign rather than domestic income.

Export Multiplier

In this simple model, the multiplier effect of an increase in exports is identical to that of
dY 1
an increase in government expenditure and is given by  . In practice it
dX s  m 
is often the case that government expenditure tend to be somewhat more biased to
domestic output than private consumption expenditure, implying that the value of m is
smaller in the case of the government expenditure multiplier than in the case of the export
multiplier. If this is the case, an increase in government expenditure will have a more
expansionary effect on domestic output than an equivalent increase in exports.

The Current Account Multiplier

The other relationships of interest are the effects of an increase in government

expenditure and of exports on the current account balance. The current account (CA) is
given by

[3.12] CA = X – Ma – mY

Totally differentiating [3.12]

d(CA) = dX – dMa – mdY

Substituting equation [3.10] for dY

m
[3.13] dCA  dX  dMa  dCa  dI  dG  dX  dMa
sm
From equation [3.13] we can derive the effects of an increase in government expenditure
on the current account balance which is given by d ( CA) dG   m s  m  0. That is,
an increase in government spending leads to a deterioration of the current account
balance which is some fraction of the initial increase in government expenditure. This is
because economic agents spend part of the increase in income on imports.

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The other multiplier of interest is the effect of an increase in exports on the current
d ( CA) m s
account balance. This is given by the expression 1   0 . Since
dX sm sm
s/s + m is less than unity, an increase in exports leads to an improvement in the current
account balance that is less than the original increase in exports. The explanation for this
is that part of the increase in income resulting from the additional exports is offset to
some extent by increased expenditure on imports.
d. The Problem of Internal and External Balance
During the period 1948 – 1973, the international monetary system was one of fixed
exchange rates, with the major currencies being pegged to the US dollar. Only in cases of
fundamental disequilibrium were authorities allowed to devalue or revalue their currency.
This meant that there was considerable interest in the relative effectiveness of fiscal and
monetary policies as a means of influencing the economy. Although economic policy-
makers generally have many macroeconomic objectives, the discussion in the 1950s and
1960s was primarily concerned with two objectives. The principal goal was one of
achieving full employment for the labour force along with a stable level of prices which
may be termed internal balance. Although governments were generally committed to
achieving full employment, it is widely recognized that expanding output in an open
economy will have implications for the current account. For instance, expanding output
and employment through expansionary fiscal policy will result in greater expenditure on
imports and consequently will lead to a deterioration of the current account. As
authorities had agreed to maintain fixed exchange rates, they were interested in running
equilibrium in the balance of payments. This later objective can be termed external
balance.
Figure 3.2

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Figure 3.2 shows the above problem of maintaining both internal and external balance
simultaneously. As a result of expansionary fiscal policy the [Y – AD(Y)] curve shifts
from [Y – AD(Y)]1 to [Y – AD(Y)]2 and the new equilibrium point is achieved with a
higher level of output (Y**) but the current account balance has deteriorated
simultaneously. The multipliers also tell us the same thing- i.e.
dY 1
 0 while d ( CA) dG   m s  m  0.
dG s  m 

A major lesson of this simple model is that the use of one instrument to achieve two
targets – internal and external balance- is most unlikely to be successful. The idea that a
country generally requires as many instruments as it has target was elaborated by the
Nobel Prize-winning economist Jan Tinbergen (1952), and is popularly known as
Tinbergen's instruments-targets rule.

To maintain the external balance, devaluation would be a good candidate. By making

imports expensive in the domestic market and by making exports cheaper in the foreign
market, devaluation can improve the current account balance and hence the country can
maintain its external balance. As the figure below shows, devaluation shifts the NX curve
upward from NXs to NXs and equilibrium can be maintained at a higher level of output
and better level of current account balance.

Figure 3.3

However, the effectiveness of devaluation in yielding the above solution depends on the
Marshall-Lerner condition (MLC). The MLC can be derived as follows.

The current account balance (CA) when expressed in terms of the domestic currency is
given by:

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[3.14] CA = X – eM; where e is the nominal exchange rate.

Totally differentiating [3.14]

d(CA)= dX – edM – Mde

Dividing by de throughout
d ( CA) dX edM
[3.15]   M
de de de

At this point we introduce two definitions; the price elasticity of demand for exports ηx is
defined as the percentage change in exports over the percentage change in price as
represented by the percentage change in the exchange rate; this gives:

dX e
x  .
de X
[3.16]
dX X
So that  x.
de e
And the price elasticity of demand for imports ηm is defined as the percentage change in
imports over the percentage change in their price as represented by the percentage change
in the exchange rate:

dM e
m   .
de M
[3.17]
dM M
So that   m.
de e

Substituting [3.16] and [3.17] into [3.15] we obtain

d ( CA) X
[3.18]  x.  m. M  M
de e

Dividing [3.18] by 1/M throughout we get

d ( CA) X
[3.19]  x.  m  1
de. M e. M

Assuming that we initially have balanced trade X = eM and hence X/eM = 1, and
rearranging [3.19] yields:

d ( CA)
[3.20]  M x  m  1
de

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Equation [3.20] is known as the Marshall-Lerner condition and says that starting from a
position of equilibrium in the current account, a devaluation will improve the current
d ( CA)
account; that is,  0 , only if the sum of the foreign elasticity of demand for
de
exports and the home country elasticity of demand for imports is greater than unity, that
is x  m  1 . If the sum of these two elasticities is less than unity then a devaluation
will lead to a deterioration of the current account.
Empirical Evidence on ηx and ηm

The possibility that devaluation may lead to a worsening rather than improvement in the
balance of payment led to much research into empirical estimates of the elasticity of
demand for exports and imports. Economists divided up into two camps popularly known
as 'elasticity optimists' who believed that the sum of these two elasticities tended to
exceed unity, and 'elasticity pessimists' who believed that these elasticities tended to be
less than unity. It was argued that devaluation may work better for industrialized
countries than for developing countries. Many developing countries are heavily
dependent upon imports so that their price elasticity of demand for imports is likely to be
very low. While for industrialized countries that have to face competitive export markets,
the price elasticity of demand for their export may be quite elastic. The implication of the
Marshall-Lerner condition is that devaluation may be a cure for some countries balance
of payment deficits but not for others.

Even for countries that devaluation is a solution for the BOP deficit, the initial J-curve
effect (see figure 3.4) may not be precluded. The J-curve shows that the deficit may
initially rise but after a lag of some time the trend would be reversed so that the BOP
would be in surplus. The J-curve effect arises mainly as elasticities are lower in the short
run than in the long run, in which case the Marshall-Lerner condition may only hold in
the medium to long run.

Figure 3.4 The J-Curve

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The possibility that in the short run the Marshall-Lerner condition may not be fulfilled
although it generally holds over the longer run leads to the phenomenon of what is
popularly knows as the J-curve effect. The idea underlying the J-curve effect is that in the
short run export volumes and import volumes do not change much, so that devaluation
leads to deterioration in the current account. However, after a time lag export volumes
start to increase and import volumes start to decline; consequently the current deficit
starts to improve and eventually moves into surplus. The issue then is whether the initial
deterioration in the current account is greater than the future improvement so that overall
devaluation can be said to work.
There have been numerous reasons advanced to explain the slow responsiveness of
export and import volumes in the short run and why the response is far greater in the
longer run; two of the most important are:

A time lag in consumer responses- It takes time for consumers in both the devaluing
country and the rest of the world to respond to the changed competitive situation.

A time lag in producer response- Even though devaluation improves the competitive
position of exports it will take time for domestic producers to expand production of
exportables.

3.2. The Mundell-Fleming Model

This model owes its origins to papers published by James Flemming (1962) and Robert
Mundell (1962, 1963). Their major contribution was to incorporate international capital
movements into formal macroeconomic models based on the Keynesian ISLM
framework. Their papers led to some dramatic implications concerning the effectiveness
of fiscal and monetary policy for the attainment of internal and external balance.

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Derivation of the IS, LM and BP curves

Both the IS and LM curves have their usual shape. At this point our emphasis would be in
deriving the BP curve.

The balance of payments schedule shows different combinations of rates of interest and
income that are compatible with equilibrium in the balance of payments.

The overall balance of payment is made up of three major components: the current
account balance (CA), the capital account (K) and the change in the authorities' reserve
(dR). By maintaining balance in supply and demand for the currency- that is external
balance- we mean that there is no need for the authorities to have to change their holdings
of foreign exchange reserves. This implies that if there is a current account deficit there
needs to be an offsetting surplus in the capital account so that the authorities do not have
to change their reserve. Conversely, if there is a current account surplus there needs to be
an offsetting deficit in the capital account to have equilibrium in the balance of payment.

Since exports are determined exogenously and imports are a positive function of income,
the higher the level of national income the smaller will be any current account surplus of
the larger any current account deficit. The net capital flow (K) is a positive function of
the domestic interest rate. Assuming that the rate of interest in the rest of the world (r f) is
fixed, the higher the domestic interest rate (r) the greater the capital inflow into the
country or the smaller any capital outflow. This relationship is expressed as:

[3.21] K = K(r – rf)

Since the balance of payment schedule shows various combinations of levels of income
and the rate of interest for which the balance of payments is in equilibrium, then

[3.22] X–M+K=0

A positive K indicates a net inflow of funds, whereas a negative K indicates a net outflow
of funds. The derivation of the BP schedule is depicted in figure 3.5.

Figure 3.5 The derivation of the BP Schedule

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Quadrant [1] shows the relationship between the current account and level of national
income. The current balance schedule slopes downwards from left to right because
increases in income lead to a deterioration of the current account. At income level Y1
there is a current account surplus of CA1, whereas at income level Y2 there is a CA
deficit of CA2. The current account surplus or deficit is transferred to quadrant [2] where
the 450 line converts the CA position to an equal capital flow of the opposite sign. With a
CA surplus CA1 there is a required capital outflow K1 to ensure balance of payment
equilibrium; while a CA deficit CA2 requires a capital inflow K2. Quadrant [3] shows the
rate of interest that is required for a given capital flow. The capital flow schedule is
downward sloping from left to right; this is because high interest rates encourage a net
capital inflow whereas low interest rates encourage a net capital outflow. To get a capital
outflow of K1 requires the interest rate to be r1, while a capital inflow of K2 requires a
higher interest rate r2.

Since income level Y1 is associated with a balance of payment surplus, there has to be an
offsetting capital outflow K1 which requires an interest rate r1; these coordinates give a
point on the BP schedule that is depicted in quadrant [4]. The BP schedule is upward
sloping because higher levels of income cause deterioration in the current account; this
necessitates a reduced capital outflow/ higher capital inflow requiring a higher interest
rate. Every point on the BP schedule shows a combination of domestic income and rate of
interest for which the overall balance of payments is in equilibrium.

The slope of the BP schedule is determined by the degree of capital mobility

internationally. The higher the degree of capital mobility then the flatter the BP schedule
would be. This is because for a given increase in income which leads to a deterioration
of the current account, the higher the degree of capital mobility, the smaller the required
rise in the domestic interest rate to attract sufficient capital inflows to ensure overall
equilibrium. When capital is perfectly mobile, the slightest rise in the domestic interest

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above the world interest rate leads to a massive capital inflow making the BP schedule
horizontal at the world interest rate. At the other extreme, if capital is perfectly immobile
internationally then a rise in the domestic interest rate will fail to attract capital inflows
making the BP schedule vertical at the income level that ensures current account balance.
Between these two extremes, that is, when we have an upward sloping BP schedule, we
say that capital is imperfectly mobile.

Equilibrium in the model

The Basic MF Model

IS: Y = c(Y) + I(r) + G + X(e) – e.M(Y, e)

LM: L(Y, r) = DC + R
.
BP: R = X(e) – e.M(Y, e) + K(r – rf)
.
DC and R are domestic credit and reserve parts of the money supply; and R is change in
reserve.

The Mundell -Fleming Model with Perfect Capital Mobility

The model assumes a small country facing perfect capital mobility. Any attempt to raise
the domestic interest rate leads to a massive capital inflow until the interest rate return to
the world interest rate. Conversely, any attempt to lower the domestic interest rate leads
to a massive capital outflow as international investors seek higher world interest rates.
The implication of perfect capital mobility is that the BP schedule for a small open
economy becomes horizontal straight line at a domestic interest rate that is the same as
the world interest rate.

Small open economy with fixed exchange rate

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Monetary Policy

The above figure depicts a small open economy with a fixed exchange rate. The initial
level of income is where the ISLMBP curves interest at the income level Y1. If the
authorities attempt to raise output by a monetary expansion, the LM curve shifts right
from LMo to LM1; there is downward pressure on the domestic interest rate and this
results in a massive capital outflow. This capital outflow means that there is pressure for
a devaluation of the currency (as shown in the above figure), and the authorities have to
intervene in the foreign exchange market to purchase the home currency with reserves.
Such purchases result in a reduction of the money supply in the hands of private agents,
and the purchases have to continue until the LM curve shifts back to its original position
at LM0 where the domestic interest rate is restored to the world interest rate. Hence, with
perfect capital mobility and fixed exchange rates, monetary policy is ineffective at
influencing output.

Fiscal Policy

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Fiscal expansion shifts the IS schedule to the right from ISo to IS1. This puts upward
pressure on the domestic interest rate and leads to a capital inflow. To prevent an
appreciation the authorities have to purchase the foreign currency with domestic
currency. This means that the amount of domestic currency held by private agents
increases and the LM0 schedule shifts to the right. The increase in the money stock
continues until the LM curve passes through the IS1 curve at the initial interest rate.
Hence, under fixed exchange rates and perfect capital mobility an active fiscal policy
alone has the ability to achieve both internal and external balance. This is an exception to
the instruments-targets rule, although monetary policy does have to passively adjust to
maintain the fixed exchange rate.

Small open economy with perfect capital mobility and floating exchange rate

Monetary policy

The initial equilibrium is at the income level Y1 where the ISo intersects the LMo. A
monetary expansion shifts the LM curve from LMo to LM1 leading to downward
pressure on the interest rate, a capital outflow, and a depreciation of the exchange rate.
The depreciation leads to an increase in exports and reduction in imports so shifting the
IS curve to the right and the LM curve to the left, so that final equilibrium is obtained at a
higher level of income. Clearly with an appropriate initial monetary expansion the
authorities could obtain both internal and external balance by monetary policy alone.

Fiscal policy

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The increase in government expenditure shits the IS schedule to the right from ISo to IS1
leading to upward pressure on the domestic interest rate resulting in a massive capital
inflow and an appreciation of the exchange rate. The appreciation of the exchange rate
results in a reduction of exports and an increase in imports, and this forces the IS
schedule back to its original position. Hence, with perfect capital mobility and a floating
exchange rate, fiscal policy is ineffective in influencing output.

Conclusion

The result that fiscal policy is very effective at influencing output under fixed exchange
rates and monetary policy is very effective under floating exchange rates with perfect
capital mobility is of considerable relevance to economic policy design. Under fixed rates
policy makers will pay more attention to fiscal policy than under floating rates when
more emphasis will be placed on monetary policy. The degree of capital mobility and the
exchange rate regime both demonstrate that appropriate economic policy design in an
open economy is very different from that in a closed economy context.

Limitations of the Mundell-Fleming Model

1. The Marshall Lerner condition: the model assumes that the Marshall Lerner
condition holds even though it is essentially of a short term model which is the
time scale under which the Marshall-Lerner conditions are least likely to be met.
2. Interaction of stocks and flows: the model ignores the problem of the interaction
of stocks and flows. According to it a current account deficit can be financed by a
capital inflow. While such a policy is feasible in the short run, a capital inflow
over time increases the stock of foreign liabilities owed by the country to the rest
of the world, and this factor means a worsening of the future current account as
interest is paid abroad. Clearly, a country cannot go on financing a current
account deficit indefinitely as the country becomes an ever-increasing debtor to
the rest of the world.
3. Neglect of the long run budget constraints: the model fails to take account of
long run constraints that govern both the private and public sector. In the long run
private sector spending has to equal its disposable income, while in the absence of
money creation government expenditure has to equal its revenue from taxation.
This means that in the long run the current account has to be in balance. One
implication of these budget constraints is that a forward looking private sector
would realize that increased government expenditure will imply higher taxation
for them in the future, and this will induce increased private sector savings today
that will undermine the effectiveness of fiscal policy.
4. Wealth Effect: the model does not allow for wealth effects that may help in the
process of restoring long run equilibrium. A decrease in wealth resulting from a
fall in foreign assets associated with a current account deficit will ordinarily lead t
a reduction in import expenditure which should help to reduce the current account
deficit. While such an omission of wealth effects on the import expenditure
function may be justified as being small significance in the short run, the omission
nevertheless again emphasizes the essentially short-term nature of the model.

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5. Neglect of supply side factors: one of the obvious limitations of the model is that
it concentrates on the demand side of the economy and neglects the supply side.
There is an implicit assumption that supply adjust in accordance with changes in
demand. In addition, because the aggregate supply curve is horizontal up to full
employment, increases in aggregate demand do not lead to changes in the
domestic price level, rather they are reflected solely by increases in real output.
6. Treatment of capital flows: one of the biggest problems of the model concerns
the modelling of capital flows. It is assumed that a rise in the domestic interest
rate leads to a continuous capital inflow from abroad. However, to expect such
flows to continue indefinitely is unrealistic because after a point international
investors will have rearranged the stocks of their international portfolios to their
desired content and once this happens the net capital inflows into the country will
cease. The only way that the country could then continue to attract capital inflows
would be a further rise in its interest rate until once again international portfolios
are restored to their desired content. Hence a country that needs a continuous
capital inflow to finance its current account deficit has to continuously raise its
interest rate. In other words, capital inflows are a function of the change in the
interest differential rather than the differential itself.
7. Exchange rate expectations: A major problem with the model is the treatment of
exchange rate expectations. The model does not explicitly model these and
implicitly presumes that the expected change is zero, which is known as static
exchange rate expectation. While this might not seem to be an unreasonable
assumption under fixed exchange rates, it is less tenable under floating exchange
rates. According to the model a monetary expansion leads to a depreciation of the
currency under floating exchange rates- in such circumstances it seems
unreasonable to assume that economic agents do not expect depreciation as well.
If agents expect depreciation this may require a rise in the domestic interest rate to
encourage them to continue to hold the currency which will have an adverse
effect on domestic investment- implying a weaker expansionary effect of
monetary policy than is suggested by the model. Indeed, the need to maintain
market confidence in exchange rates can severely restrict the ability of
government to pursue expansionary fiscal and monetary policies.

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