Chapter 6 The Macroeconomics of An Open Economy

03/25/2024
N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
CHAPTER Open economy

macroeconomics
6
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Outline
1. The exchange rate

2. Foreign exchange market
3. International trade
4. International investment
5. The balance of payment
6. The effect of economic policies
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management system for classroom use.
1. The exchange rate
• Definition of the (nominal) exchange rate

• Changes in the exchange rate
• Definition the real exchange rate

• Changes in the real exchange rate
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03/25/2024
Definition of the exchange rate
• An exchange rate (or nominal exchange rate) is a rate at

which one currency will be exchanged for another currency.
• It can be defined as:
– The value of one unit of a foreign currency in terms of a
domestic currency (Giá của ngoại tệ tính theo nội tệ)
($ 1 = VND 23000, E = 23000/1)
– The value of one unit of a domestic currency in terms of a
foreign currency (Giá của nội tệ tính theo ngoại tệ)
(VND 1 = $ 1/23000, e = 1/23000)
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Changes in the exchange rate
• Appreciation (lên giá):

– an increase in the value of the domestic currency (đồng
nội tệ tự lên giá)
E↓
• Depreciation (giảm giá):
– a decrease in the value of the domestic currency (đồng nội
tệ tự mất giá giá)
E↑
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Changes in the exchange rate
• Revaluation (nâng giá):

– an increase in the value of the domestic currency as the
result of the CB’s intervention (đồng nội tệ lên giá do can
thiệp của CB)
E↓
• Devaluation (phá giá):
– a decrease in the value of the domestic currency as the
result of the CB’s intervention (đồng nội tệ giảm giá giá do
can thiệp của CB)
E↑
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Definition of the real exchange rate
• The real exchange rate (RER, ) between two currencies is the

product of the nominal exchange rate (e.g. the dong cost of a
dollar) and the ratio of prices between the two countries.
𝑬 ∙ 𝑷∗
𝜺=
𝑷
: the real exchange rate;

E: nominal exchange rate;
P*: price in another country
P: domestic price
Example
• 1 kg of coffee bean has a price of $ 2.08 in USA, and Dong 40,000

in VN. The nominal exchange rate of $ 1 in VND is 23,000
• What is the real exchange rate between VND and US$?
𝟐𝟑,𝟎𝟎𝟎 ∙𝟐,𝟎𝟗
𝜺= 𝟒𝟎,𝟎𝟎𝟎
= 𝟏. 𝟐
• What does  (=1.2) mean ?

• The price of coffee bean in the US is 1.2 times of that in VN (Giá
cà phê hạt tại US đắt gấp 1.2 lần tại VN)
The real exchange rate with many goods
• Real exchange rate = (e x P)/P*

= price of a domestic basket of goods relative to price of a
foreign basket of goods
• P: VN price level, e.g., Consumer Price Index, measures the
price of a basket of goods
• P* = foreign price level
– If VN real exchange rate appreciates, VN goods become more
expensive relative to foreign goods.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
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management system for classroom use.
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03/25/2024
Changes in the real exchange rate
𝑬 ∙ 𝑷∗
𝜺=
𝑷
• The real exchange rate will change when:

– Relative price change (inflation) between one country and the
other
– A change in the nominal exchange rate
2. Foreign exchange market
• Foreign exchange supply

• Foreign exchange demand
• Equilibrium in foreign exchange market
• Changes in foreign exchange market
Foreign exchange supply
• Sources of foreign exchange (forex) supply

– Export of goods and services.
– Receiving gifts/unilateral transfers from outside country.
– Investment made in the country by foreigners.
– Tourism in the country (People visiting the country have to
sell their foreign currency)
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• Determinants of foreign exchange supply

– Exchange rate
– Exports
– Capital inflow
• The foreign exchange supply function

SF = f (exports, capital inflow, E)
• Foreign exchange supply curve
E
S
Foreign Exchange
Foreign exchange demand
• Sources of foreign exchange (forex) demand

– Import of Goods and Service.
– Sending Gifts/Unilateral Transfers Abroad.
– Investment Abroad (Purchase of Assets abroad)
– Tourism (People visiting abroad have to purchase foreign currency)
– Speculation (People buy foreign currency if they expect its price to
go up)
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• Determinants of foreign exchange demand

– Exchange rate
– Imports
– Capital outflow
• The foreign exchange demand function

DF = f (imports, capital outflow, E)
• Foreign exchange demand curve
E
D
Foreign Exchange
Equilibrium in foreign exchange market
E
D
S
Equilibrium K1
exchange rate
F1 Foreign Exchange
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Changes in foreign exchange market
E D2
D1
K2 S
E2
E1 K1
F1 F2 Foreign Exchange
3. Exchange rate regimes
• Floating exchange rate regime (Cơ chế tỷ giá thả nổi)

– The exchange rate is determined by the foreign exchange market
3. Exchange rate regime
• Fixed exchange rate regime (Cơ chế tỷ giá cố định)

– Ties the official currency exchange rate to another country's
currency or the price of gold
– (1) The CB intervenes the foreign exchange market by
buying/selling foreign currency when there is foreign currency
surplus/shortage
– (2) But buying/selling foreign currency causes increase/decrease in
domestic money supply
– (3) To keep MS unchanged, the CB needs to sell/buy bonds
– The combination of (1), (2) and (3) is call sterilization
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3. Exchange rate regime
• Managed exchange rate regime (Cơ chế tỷ giá thả nổi có quản lý)
– The CB lets the exchange rate to be determined by the market
when the exchange rate is within a manageable band
– When it is out of the manageable band, the CB intervenes via
sterilization
International flows of goods and assets
• Two main transactions between one economy and the rest of

the world (ROW)
– International flows of goods and services (trade)

– International flows of financial assets (investment)
© 2023 Van Tran. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license
23
4. International trade
• Benefits of trade
• Determinants of trade
• Trade policies
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Benefits of trade
Panel (a) shows the production opportunities available to Frank the farmer and Rose
the rancher.
Benefits of trade
Determinants of exports
• Determinants of exports
– Income (the size) of the exporting country (Y)
– Income (the size) of the rest of the world (Y*)
– Exchange rate (E)
– Relative domestic/ROW prices
– Tastes of consumers in ROW…
• The export function

X = f (Y, Y*, E)
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Determinants of imports
• Determinants of imports
– Income (the size) of the exporting country (Y)
– Income (the size) of the rest of the world (Y*)
– Exchange rate (E)
– Relative domestic/ROW prices
– Tastes of domestic consumers …
• The import function

M = f (Y*, Y, E)
Net exports
• Net exports (NX)

NX = X – M
– NX > 0 trade surplus
– NX < 0 trade deficit
– NX = 0 trade balance
Trade policies
• Tariff barrier (Hàng rào thuế quan)

• Non-tariff barriers (Hàng rào phi thuế quan)
– Quota (Hạn mức xuất, nhập khẩu)
– Export/import subsidy (Trợ giá xuất khẩu/nhập khẩu)
– Quality (Tiêu chuẩn kỹ thuật)
– Anti-dumping (Chống bán phá giá)
– Other barriers (các thủ tục khác…)
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5. International investment
• Definition
• Benefits of international investment
• Types of international investment
• Determinants of international capital flows
Definition
• International Investments are those investments that are made

outside the domestic markets. (Đầu tư quốc tế là hoạt động đầu
tư được thực hiện ở thị trường nước ngoài).
Benefits of international investment
• Investment diversification
– Diversification is one of the primary benefits of international
investing. ...
• Multiple investment options. ...
• Currency appreciation. ...
• Low cost of transaction. ...
• Protection against frauds.
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Types of international investment
• Foreign Indirect Investment (Đầu tư gián tiếp)

– Official Development Aid (ODA)
– Non-government Oganisations fund (NGOs)
– Stock Market (Thị trường chứng khoán)
– International Loans (Vay)
• Foreign Direct Investment (Đầu tư trực tiếp)
Components of capital flows

Net capital outflow (NCO)
• refers to the purchase of foreign assets by domestic residents
minus the purchase of domestic assets by foreigners.
• When a Japanese residents buys a bond issued by the U.S.
government, the purchase reduces the U.S. net capital outflow
• NCO > 0: net capital outflow

NCO < 0: net capital inflow
Determinants of net capital outflows

The interest rate
• The real interest rates being paid on foreign assets.
• The real interest rates being paid on domestic assets.
• Relative (real) interest rate between an economy and the ROW
Business environment
• The perceived economic and political risks of holding assets
abroad.
• The government policies that affect foreign ownership of
domestic assets.
The exchange rate
• Exchange rate
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Determinants of net capital outflows
Net capital outflow = f (i – i* , E,  )
6. Open economy identities
• Trade and investment identity

• The national income identity
• The saving and investment identity
• Trade, saving, and investment identity
Trade and investment identity
• Every transaction that affects NX also affects NCO by the

same amount (and vice versa)
• eg. VN exports and NX increases, the foreigner pays with
currency or assets, so the VN acquires some foreign
assets, causing NCO to rise.
NCO = NX (1)
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• Every transaction in the balance of payments is recorded twice in

accordance with standard accounting practice.
– Ex. U.S. manufacturer, John Deere, exports $50 million worth
of farm equipment to Ireland.
• A credit of $50 million to the current account
( - $50 million worth of farm equipment or physical assets)
• A debit of $50 million to the capital/financial account
( + $50 million worth of Euros or financial assets)
– Notice that the two transactions offset each other.
Theoretically, the balance payments should always equal
zero…Theoretically
• Remember double entry bookkeeping?

• The Current Account and the Capital Account should zero each
other out.
• That is… If the Current Account has a negative balance (deficit),
then the Capital Account should then have a positive balance
(surplus).
• Ex. The constant net inflow of foreign financial capital to the
United States (capital account surplus) is what enables us to
import more than we export (current account deficit)
The national income identity
• In an open economy: Y = C + I + G + NX (2)
NX = Y – (C + I + G) (3)
Net exports = output (gross income) – domestic spending
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The saving and investment identity
• In an open economy : Y = C + I + G + NX (2)

• National saving: S=Y–C–G (4)
• (2) and (4) yeild
Y – C – G = I + NX (5)
S = I + NX (6)
• We also have NX = NCO (1)
• (6) and (1) yeild
S = I + NCO (7)
Saving = Domestic investment + Net capital outflow
Trade, saving, and investment identity

• Trade surplus: Exports > Imports
• Net exports > 0
• Y > Domestic spending (C+I+G)
• S>I
• NCO > 0
• Trade deficit: Exports < Imports
• Net exports < 0
• Y < Domestic spending (C+I+G)
• S<I
• NCO < 0
Balance of payment
• Definition
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Definition
• The balance of payments (BOP) is a statement of all transactions

made between entities in one country and the rest of the world
over a defined period of time. (Cán cân thanh toán thể hiện tất
cả các giao dịch của một quốc gia với phần còn lại của thể giới
trong một giai đoạn nhất định.
• Measure of money inflows and outflows between the VN and
the Rest of the World (ROW)
Components of BOP
• The current account (Tài khoản vãng lai, CA)

• The capital account (Tài khoản vốn, KA)
• Errors and Omissions (Sai số thống kê, )
Definition of The Current Account
• records net flow of goods, services, and unilateral transfers.

• Current account measures the nation's earnings and spendings
abroad
• Current account ghi chép các giao dịch liên quan đến xuất khẩu
và nhập khẩu hàng hóa và dịch vụ và các khoản chuyển nhượng
đơn phương
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Components of the Current Account

• Balance of trade (net exports)
– Exports of Goods/Services – Import of Goods/Services
– Exports create a credit to the balance of payments
– Imports create a debit to the balance of payments
• net primary income or factor income
– Income earned by VN owned foreign assets – Income paid to
foreign held VN assets
– Ex. Interest payments on VN owned Brazilian bonds – Interest
payments on German owned VN Treasury bonds
• Net Transfers (tend to be unilateral)
– Foreign Aid  a debit to the current account
– Ex. Laos migrant workers send money to family in Laos
• CA = NX
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Definition of The capital Account
• The capital account (KA) records the flows of investment

transaction between an economy and ROW
• Tài khoản vốn ghi chép các giao dịch mua bán tài sản thực hoặc
tài sản tài chính giữa một nền kinh tế với phần còn lại của thế
giới
Components of The capital Account
• Direct investment in VN is a credit to the capital account

– Ex. The Samsung Factory in Bac Ninh
• Direct investment by VN firms/individuals in a foreign country
are debits to the capital account
– Ex. The Viettel project in Myanmar
• Purchase of foreign financial assets represents a debit to the

capital account.
– Ex. VCB buys stock in Singapore.
• Purchase of domestic financial assets by foreigners represents a
credit to the capital account.
– The Warrent Bufet buys a large stake in the Vingroup.
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The balance of payment
• BP = CA + KA + 
• BP = 0: balance of payment
• BP > 0: surplus in the balance of payment
• BP < 0: deficit in the balance of payment
Changes in the exchange rate and the BOP
• We have  = EP*/P i.e. E and  have a positive relationship

• E    X, M  NX (trade surplus)
 capital inflow, capital outflow  KA
 BOP (get improved)
• E    X, M  NX (trade deficit)

 capital inflow , capital outflow  KA
 BOP (get worse)
57
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The Mundell – Flemming Model

(The IS – LM – BP model)
(IS) : Y = C(Y – T) + I(Y, i) + G + NX(Y*, Y, E)

(LM): MS/P = MD(Y, i)
(BP) : CA(Y, Y*, E) + KA(i, i*, E) = 0
• Exogenous variables : T, G, MS, Y*, P*, P, i*, E

• Endogenous variables: Y, i
• Giả định: nền kinh tế nhỏ và mở, do đó trong ngắn hạn Y*, P*, P,
i* không thay đổi
• Các kịch bản:
– Tỷ giá ngoại tệ: Cố định , Thả nổi
– Di chuyển vốn : Tự do hoàn toàn, Không tự do hoàn toàn
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The Balance of Payment Relation

Thị trường vốn thế giới i BP
i1 = i*
i2
i3
-∆KA -∆KA3 -∆KA2 Y3 Y2 Y1 Y
∆CA2
Thị trường hàng
hóa thế giới
∆CA3
450
∆CA 59
The BP curve
• Đường BP mô tả các kết hợp khác nhau giữa thu nhập và lãi suất mà tại đó
cán cân thanh toán cân bằng
• Những điểm bên dưới đường BP thể hiện thâm hụt cán cân thanh toán
(e.g. thu nhập tăng trong khi lãi suất không đổi sẽ làm cho NX giảm và do
đó CA giảm).
• Tương tự, những điểm phía trên đường BP thể hiện thặng dư cán cân
thanh toán.
Interest rate,
i BP
BP>0
BP<0
60
Output level, Y
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The BP Relation
• Độ dốc của đường BP phụ thuộc vào tính linh hoạt của thị
trường vốn
i BP>0 i
BP BP
A BP>0
iA
BP<0 BP<0
iB
Y Y
Low capital mobility High capital mobility
The BP Relation
• Độ dốc của đường BP phụ thuộc vào tính linh hoạt của thị
trường vốn
i i BP
BP>0
BP
BP<0
Y Y
Perfect capital mobility Zero capital mobility
Sự dịch chuyển đường BP
• Đường BP sẽ dịch chuyển khi Y*, i* hay E thay đổi

• Khi Y* giảm, cùng với giảm E và tăng i* sẽ làm BP dịch chuyển sang
trái đến BP” (khi i không thay đổi, những điểm trên BP cũ thể hiện thâm
hụt).
• Khi Y* tăng, cùng với tăng E và giảm i* sẽ làm BP dịch chuyển sang
phải đến BP’ (khi i không thay đổi, những điểm trên BP cũ thể hiện
thặng dư).
Interest rate, BP’’

i BP BP’
63
Output level, Y
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Cân bằng trong mô hình Mundell-Fleming

• Cân bằng trong mô hình là giao điểm của ba đường IS-LM-BP
Cân bằng trong mô hình với

Interest rate, BP lưu chuyển vốn không hoàn
i toàn tự do
LM
Equilibrium
interest
IS
Equilibrium Output level, Y

output 64
Balance at home and abroad

(The Mundell Flemming model)
(IS) : Y = C(Y – T) + I(Y, i) + G + NX(Y*, Y, E)

(LM): MS/P = MD(Y, i)
(BP) : CA(Y, Y*, E) + KA(i, i*, E) = 0

 Assumptions:
 The economy is small and open
• i.e. Y*, P*, P, i* are unchanged in the short-run
 Exchange rate regime: floating
 Capital mobility: perfect

• i.e. i tends to be equal to i*, suppose i > i*, there is capital
inflow, this raise the capital supply and hence pulls the i down
until i = i*, and vice versa
• The BP curve is horizontal, which starts from point i*
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i
LM
BP
E
i = i*
IS
Y
Y1
The effects of economic policies

• The effects of an expansionary fiscal policy

• The effects of an expansionary monetary policy
• The effects of a contractionary fiscal policy (IS)
• The effects of a contractionary monetary policy (IS)
• The effects of a devaluation policy
Expansionary fiscal policy
i LM1
E’
E1 E2 BP
i = i*
IS2
IS1
Y1 Y
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Expansionary monetary policy
i LM1
LM2
E1 E2 BP
i = i*
E’
IS1
Y1 Y
The effects of a devaluation policy
i LM1
E1
BP
i = i*
E’
IS1
Y1 Y

 Assumptions:
 The economy is small and open
• i.e. Y*, P*, P, i* are unchanged in the short-run
 Exchange rate regime: floating
 Capital mobility: imperfect

• The BP curve is upward sloping
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Expansionary fiscal policy

• Chính sách tài khóa mở rộng làm IS dịch chuyển sang phải và làm Y và i tăng.
• Do đó, dòng vốn có xu hướng chạy vào. BOP thặng dư, và do đó đồng nội tệ lên giá.
• Sự lên giá làm BP dịch chuyển lên, đồng thời làm NX xấu đi và do đó IS dịch chuyển sang trai
• Kết quả: Y tăng, i tăng, Fiscal policy is not very effective.
i LM0
BP1
G↑ A’
BP0
A1
IS’
A0
IS1
IS0
73
Y
Expansionary monetary policy
• Chính sách tiền tệ mở rộng làm đường LM chạy xuống, do đó làm tăng Y và giảm i.
• i giảm sẽ làm dòng vốn chạy ra có xu hướng tăng, BP thâm hụt và do đó đồng nội tệ giảm giá.
• Đồng nội tệ giảm giá làm BP chạy xuống, và làm cho xuất khẩu ròng tăng. Kết quả: IS chạy
sang phải.
• Kết quả cuối cùng: Y tăng, i giảm. Chính sách này hiệu quả
i LM0
BP0
LM1
BP1
A0
A1
IS0 IS1
74
Y
25

Chapter 6 The Macroeconomics of An Open Economy

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Chapter 6 The Macroeconomics of An Open Economy

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03/25/2024

CHAPTER Open economy

1. The exchange rate

1. The exchange rate

• Definition of the (nominal) exchange rate

• Definition the real exchange rate

Definition of the exchange rate

• An exchange rate (or nominal exchange rate) is a rate at

Changes in the exchange rate

• Appreciation (lên giá):

Changes in the exchange rate

• Revaluation (nâng giá):

Definition of the real exchange rate

• The real exchange rate (RER, ) between two currencies is the

: the real exchange rate;

• 1 kg of coffee bean has a price of $ 2.08 in USA, and Dong 40,000

• What does  (=1.2) mean ?

The real exchange rate with many goods

• Real exchange rate = (e x P)/P*

Changes in the real exchange rate

• The real exchange rate will change when:

2. Foreign exchange market

• Foreign exchange supply

Foreign exchange supply

• Sources of foreign exchange (forex) supply

Foreign exchange supply

• Determinants of foreign exchange supply

• The foreign exchange supply function

Foreign exchange supply

• Foreign exchange supply curve

Foreign exchange demand

• Sources of foreign exchange (forex) demand

Foreign exchange demand

• Determinants of foreign exchange demand

• The foreign exchange demand function

Foreign exchange demand

• Foreign exchange demand curve

Equilibrium in foreign exchange market

Changes in foreign exchange market

3. Exchange rate regimes

• Floating exchange rate regime (Cơ chế tỷ giá thả nổi)

3. Exchange rate regime

• Fixed exchange rate regime (Cơ chế tỷ giá cố định)

3. Exchange rate regime

International flows of goods and assets

• Two main transactions between one economy and the rest of

– International flows of goods and services (trade)

• The export function

• The import function

• Net exports (NX)

• Tariff barrier (Hàng rào thuế quan)

• International Investments are those investments that are made

Benefits of international investment

Types of international investment

• Foreign Indirect Investment (Đầu tư gián tiếp)

Components of capital flows

• NCO > 0: net capital outflow

Determinants of net capital outflows

Determinants of net capital outflows

Net capital outflow = f (i – i* , E,  )

6. Open economy identities

• Trade and investment identity

Trade and investment identity

• Exogenous variables : T, G, MS, Y, P, P, i*, E

• Đường BP sẽ dịch chuyển khi Y, i hay E thay đổi