15-01-2021

The Open Economy

By
Prof. Vishwa Ballabh

International Capital Flows and Trade Balance

Both in open and closed economy financial markets and good markets are closely related.
Let see the relationship

Y=C+I+G+NX(Net Export)

Subtract C and G from both sides to obtain

Y-C-G=I+ NX
National Saving (S) = Y-C-G

The Sum of private saving = Y-T-C &

Public Saving = T (tax)-G

Therefore, S=I+NX
Subtract I from both side of the equation
S-I=NX
Net Capital outflow= Trade Balance

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International Flows of Goods and Capital:

Summary

The Model
To build the model of the small open economy, three assumption are taken:
 The economy's output Y is fixed by the factor of productions and the production function
Y = Y*=F (K*,L*)
 Consumption C is positively related to disposal income Y-T
C=C(Y-T)
 Investment I is negatively related to the real interest rate r.
I=I(r)

NX=(Y-C-G)-I
NX=S-I

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Saving and Investment in a small Open

economy

In a closed economy, the real interest rate adjust to equilibrium saving and investment. In a small open economy the
interest rate determine in world markets. The difference between saving and investment determines the Trade
balance. Here, there is a trade surplus. Because at the world interest rate, saving exceed s investment.

A fiscal Expansion at Home in s small open

Economy

An increase in government purchases or a reduction in taxes reduces national saving and thus shifts the saving
schedule to the left from S1 to S2. The result is trade deficit.

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A Fiscal Expansion Abroad in a small Open

Economy

A fiscal expansion in a foreign economy large enough to influence world saving and investment raises the world
interest rate from r1* to r2*. The higher world interest rate reduces investment in this small open economy,
causing a trade surplus.

A shift in the Investment Schedule in a small

open Economy

An outward shift in the investment schedule from I(r)1 to I(r)2 increases the amount of investment at the world
interest rate r*. As a result, investment now exceeds saving, which means the economy is borrowing from abroad
and running a trade deficit.

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The Nominal Exchange Rate

The Nominal Exchange rate is the relative

price of the currency of two countries.

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.

Real Exchange rate(Є)= Nominal Exchange rate(e) ratio of Price

levels(P/P*)

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The Determinants of the Real Exchange Rate

 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 export 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 world interest rate.

How the real Exchange rate is Determined

The real exchange rate is determined by the intersection of the vertical line representing saving minus investment
and the downward- sloping net-export schedule. At this intersection, the quantity of INR supplied for the flow of
capital abroad equals the quantity of INR demanded for the net export of goods and services.

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The Impact of Expansionary Fiscal Policy at

Home on the Real Exchange Rate.

Expansionary fiscal policy at home, such as an increase in government purchases or a cut in taxes, reduces national
saving. The fall in saving reduces the supply of INR to be exchanged into foreign currency, from S1-I to S2-I

The Impact of Expansionary Fiscal Policy

Abroad on the Real Exchange Rate

Expansionary fiscal policy abroad reduces world saving and raises the world interest rate from r*1 to r*2. The increase
in the world interest rate reduces investment at home, which in turn raises the SS of INR to be exchange into foreign
currencies. As a result, the equilibrium real exchange rate falls from Є1 to Є2

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The Impact of an increase in Investment

Demand on the Real Exchange Rate

An increase in investment demand raises the quantity of domestic investment from I1 to I2. As a result, the SS of
INR to be exchanged into foreign currencies falls from S-I1 to S-I2. This falls in supply raises the equilibrium real
exchange rate from Є1 to Є2

The Impact of Protectionist Trade Policies on the

Real Exchange Rate

A protectionist trade policy, such as a ban on imported cars, shifts the net exports schedule from NX(Є)1 to NX(Є)2, which raise the
real exchange rate from Є1 to Є2. Note that despite the shift in the net export schedule the equilibrium level of net export is
unchanged

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The Determinates of the Nominal Exchange

Rate

Real Exchange Rate (Є) = Nominal Exchange Rate(e) * Ratio of Price levels(P*/P)

We can write the nominal exchange rate as

e = Є * (P*/P)

% change in e= %change in Є +% change in P*- %Change in P

% change in e= %change in Є+ (π*- π)[ Difference in inflation rate]

The Determinants of the

Nominal Exchange Rate
 So e depends on the real exchange rate
and the price levels at home and abroad…
 …and we know how each of them is
determined:
M*
 L * (r *   *, Y * )
P*
P*
e  ε 
P
M
 L (r *   , Y )
NX (ε )  S  I (r *) P

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The Determinants of the

Nominal Exchange Rate
P*
e  ε 
P
 We can rewrite this equation in terms of
growth rates.

e ε P * P ε
     *  
e ε P *
P ε
 For a given value of ε,
the growth rate of e equals the difference
between foreign and domestic inflation rates.

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

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Purchasing Power Parity (PPP)

 PPP: e P = P* Cost of a basket of
foreign goods, in
foreign currency.

Cost of a basket of Cost of a basket of

domestic goods, in domestic goods, in
foreign currency. domestic currency.

 Solve for e : e = P*/P

 PPP implies that the nominal exchange rate
between two countries equals the ratio of
the countries’ price levels.

Purchasing Power Parity (PPP)

 If e = P*/P,
P P* P
then ε e *   * 1
P P P
and the NX curve is horizontal:
ε
S I Under PPP, changes
in (S  I ) have no
impact on ε or e.
ε =1 NX

NX

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Does PPP hold in the real world?

No, for two reasons:
1. International arbitrage not possible.
 nontraded goods
 transportation costs
2. Goods of different countries not perfect
substitutes.
Nonetheless, PPP is a useful theory:
• It’s simple & intuitive
• In the real world, nominal exchange rates
have a tendency toward their PPP values over
the long run.

Interest Parity and uncovered interest rate.

Year(t) Year (t+1)

Indian Bond INR 1 INR(1+it)

INR 1 Et(1+it*).1/Eet+1

US Bond $ Et Et(1+it *)

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INR(1+it) = INR Et(1+it*)

Eet+1
INR(1+it) = (1+it*)
Eet+1
INR(1+it) = (1+it*) – Expected depreciation of the foreign currency

Interest Parity- Domestic interest must be equal to the foreign interest rate minus the
expected rate of depreciation of the foreign currency.

Introduction -Floating & Fixed Exchange Rates

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Arguments for Two Exchange rate - Floating vs. Fixed

The Mundell-Fleming Model

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The Mundell-Fleming Model

The IS*Curve: Goods Market eq’m

The Mundell-Fleming Model

The LM*Curve: Money Market eq’m

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Equilibrium in the Mundell-Fleming Model

Monetary Policy under Floating Exchange rate

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Lessons about Monetary

Fixed Exchange Rates

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Monetary Policy under Fixed Exchange Rate

Summary of Policy Effects in M-F Model

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The Impossible Trinity

Thank You

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