OPEN ECONOMY

Source of text materials: Mankiw (2009) Macroeconomics, 7th Ed.
Source of data materials: World Bank
Imports and exports as a percentage of output: ASEAN, 2010
0
50
100
150
200
250
Exports of goods and services (% of
GDP)
The International Flow of Capital and Goods
The Role of Net Exports

 In an open economy, some output is sold domestically
and some is exported to be sold abroad.
 Then, the output Y is expressed in the identity:

Y = Cᵈ + Iᵈ + Gᵈ + X

Cᵈ = consumption of domestic goods & services
Iᵈ = investment in domestic goods & services
Gᵈ = gov’ purchases of domestic goods & services
X = exports of domestic goods & services
The International Flow of Capital and Goods
 Note that all domestic spending are equals domestic
spending on domestic goods & services plus
domestic spending on foreign goods & services. So:

C = Cᵈ + Cᶠ
I = Iᵈ + Iᶠ
G = Gᵈ + Gᶠ

Y = (C – Cᶠ) + (I – Iᶠ) + (G – Gᶠ) + X
Y = C + I + G + X – (Cᶠ + Iᶠ + Gᶠ)
Y = C + I + G + X – IM
Y = C + I + G + NX
Substitute into : Y = Cᵈ + Iᵈ + Gᵈ
+ X
The International Flow of Capital and Goods
 Therefore, we can conclude that:

NX = Y – (C + I + G)

 If output exceeds domestic spending, we export the
difference: net exports are positive (NX > 0).
 If output falls short of domestic spending, we import
the difference: net exports are negative (NX < 0).
Net Exports Output Domestic Spending
The International Flow of Capital and Goods
International Capital Flows & the Trade
Balance

 Recall from Chapter 3: financial markets and goods
markets are closely related.
Y = C + I + G + NX
Y – C – G = I + NX
S = I + NX
S – I = NX
Net Capital Outflow = Trade Balance
Saving & Investment in a Small Open Economy
Capital Mobility & the World Interest Rate

 Since the trade balance equals net capital outflow, our
model focuses on saving and investment.
 Instead of using equilibrium interest rate, we rather
use world interest rate (r*) because the economy may
run a trade surplus or trade deficit.

r = r *

 However, this is represents the case of small open
economy with perfect capital mobility.
Saving & Investment in a Small Open Economy
 Saving and investment in small open economy:
r
I, S
0
I(r
)
S
r*
NX
Saving & Investment in a Small Open Economy
How Policies Influence the Trade Balance

 Fiscal Expansion at Home
an increase in government expenditure or a reduction
in taxes reduces national saving, thus: trade deficit.

 Fiscal Expansion Abroad
a fiscal expansion at foreign big open economy is
strong enough to raise the world interest rate, thus:

 Shift in the Investment Schedule
an outward shift in investment schedule increases the
actual investment at r* and exceeds saving, thus:
Exchange Rates
“Is the price of which residents of two
countries trade with each other
during the trade transaction.”
Exchange Rates
Nominal & Real Exchange Rates

 The Nominal Exchange Rates
is the relative price of the currencies of two countries.

 Appreciation is the rise in the exchange rate
(strengthening of the currency)
 Depreciation is the fall in the exchange rate
(weakening of the currency)
Exchange Rate =
Foreign Currency
Local Currency
Exchange Rates
 Trend in Rupiah’s exchange rate:
0
0.0001
0.0002
0.0003
0.0004
0.0005
0.0006
0.0007
1987 1990 1993 1996 1999 2002 2005 2008 2011
Official Exchange
Rate (\$/Rp, period…
Exchange Rates
 Comparison in ASEAN’s currency exchange rate
(2011):
Country \$/Local Local/\$
Singapore 0.795054205 1.2578
Brunei Darussalam 0.794967525 1.2579
Malaysia 0.326797064 3.0600
Thailand 0.032795774 30.4917
Philippines 0.023087684 43.3131
Cambodia 0.000246396 4058.5000
Lao 0.000121083 8258.7701
Indonesia 0.000114019 8770.4333
Vietnam 0.000048757 20509.7500
Exchange Rates
 The Real Exchange Rates
is the relative price of the goods of two countries
(also known as terms of trade).

 If the real exchange rate (ϵ) is high, foreign goods
are relatively cheap, and domestic goods are
relatively expensive.

Real Exchange
Rate
=
Nominal Exchange Rate x Domestic Price
Foreign Price
ϵ
=
e
P
P*
Exchange Rates
The Real Exchange Rate & the Trade
Balance

 Since the real exchange rate express the price ratio
of domestic goods to foreign goods, it affects the
demand for these goods (which turns into Net
Exports = NX).

NX = NX(ϵ)

 Low exchange rate → cheap domestic goods →
exports
 High exchange rate → cheap foreign goods →
imports

Exchange Rates
 Relationship between real exchange rate and net
export:
ϵ
Net
Exports
0
NX(ϵ)
Exchange Rates
The Determinant of the Real Exchange Rate

1. The real exchange rate (ϵ) is related to net exports
(NX). It appears to has negative correlation.
2. The trade balance (the net exports) must equal to
net capital outflow, which in turn equals to savings
minus investment (S-I). Saving is fixed by the
consumption function and fiscal policy; Investment
is fixed by the investment function and world
interest rate.
Exchange Rates
How Policies Influence the Real Exchange
Rate

 Fiscal Expansion at Home
an increase in government expenditure or a reduction in
taxes reduces national saving, thus: increasing ϵ,
decreasing NX.
 Fiscal Expansion Abroad
a fiscal expansion at foreign big open economy is strong
enough to raise the world interest rate and reduce world
saving, thus: decreasing ϵ, increasing NX.
 Shift in the Investment Schedule
an outward shift in investment schedule increases the
actual domestic investment, thus: increasing ϵ, decreasing
NX.
Exchange Rates
 How the real exchange rate is determined:
Net
Exports
NX(ϵ)
S-I
ϵ
ϵ*
Exchange Rates
The Effect of Trade Policies

 Protectionist Trade Policies
a ban on imported commodities or a regulate on
particular import quota or impose a tariff on imported
commodities would raise the demand for net exports,
thus: increasing ϵ, unchanged NX (because the
protectionist trade policy does alter neither saving nor
investment).
Exchange Rates
The Determinants of the Nominal Exchange Rate

 Recall the relationship of two exchange rates:
ϵ = e
P
P*
Δe
=
Δϵ
+
ΔP*

ΔP
e ϵ P* P
e = ϵ
P*
P
Δe
=
Δϵ
+ ( π* – π )
e ϵ
Exchange Rates
The Special Case of PPP

 The Law of One Price states that the same good
cannot sell for different prices in different places at the
same time.
 Arbitrageurs are people who specialize in ‘buying
low’ in one market and ‘selling high’ in another. This
opportunistic thereby ensuring that prices are
equalized in the two markets.

 Purchasing Power Parity (PPP) is the international
term for the Law of One Price. If international arbitrage
is possible, then a currency must have the same
purchasing power in every country.
Exchange Rates
 PPP suggested that NX are highly sensitive to ϵ:
Net
Exports
NX(ϵ)
S-I
ϵ
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