CHAPTER FIVE

macro The Open Economy

macroeconomics
fifth edition

N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich

© 2003 Worth Publishers, all rights reserved

 Chapter objectives
 accounting identities for the open
economy
 small open economy model
 what makes it “small”
 how the trade balance and exchange
rate are determined
 how policies affect trade balance &
exchange rate

CHAPTER 5 The Open Economy slide 2

 Imports and Exports
as a percentage of output: 2002
50%
50%
45%
45%
40%
40%
35%
Percentage of GDP

35%
Percentage of GDP

30%
30%
25%
25%
20%
20%
15%
15%
10%
10%
5%
5%
0%
0%
Canada France Germany Italy Japan Mexico U.K. USA
Canada France Germany Italy Japan Mexico U.K. USA
Imports
Imports Exports
Exports source: OECD

CHAPTER 5 The Open Economy slide 3

 In an open economy,
 spending need not equal output
 saving need not equal investment

CHAPTER 5 The Open Economy slide 4

 Preliminaries
d f
C C C superscripts:
d f d = spending on
I I I domestic goods
d f
G G G f = spending on
foreign goods
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  C d  I d  G d  EX
 (C  C f )  (I  I f )  (G  G f )  EX

 C  I  G  EX  (C f  I f  G f )

 C  I  G  EX  IM

 C  I  G  NX

CHAPTER 5 The Open Economy slide 6

 The national income identity
in an open economy

Y = C + I + G + NX

or, NX = Y – (C + I + G )

domestic
spending
net exports
output

CHAPTER 5 The Open Economy slide 7

 Trade surpluses and deficits

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

CHAPTER 5 The Open Economy slide 8

 U.S. net exports (% of GDP), 1975-2003
2%
2%

1%
1%

0%
0%

-1%
-1%

-2%
-2%

-3%
-3%

-4%
-4%

-5%
-5%
1975
1975 1980
1980 1985
1985 1990
1990 1995
1995 2000
2000

CHAPTER 5 The Open Economy slide 9

 International capital flows
 Net capital outflows
=S –I
= net outflow of “loanable funds”
= net purchases of foreign assets
the country’s purchases of foreign assets
minus foreign purchases of domestic assets

 When S > I, country is a net lender

 When S < I, country is a net borrower

CHAPTER 5 The Open Economy slide 10

The link between trade & cap. flows

NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
= S – I
trade balance = net capital outflows

Thus,
Thus,
aa country
country with
with aa trade deficit ((NX
trade deficit NX << 00))
isis aa net borrower ((SS << II ).).
net borrower

CHAPTER 5 The Open Economy slide 11

The world’s largest debtor nation
 U.S. has had large trade deficits, been a
net borrower each year since the early 1980s.
 As of 12/31/2002:
 U.S. residents owned $6.9 trillion worth of
foreign assets
 Foreigners owned $9.2 trillion worth of U.S.
assets
 U.S. net indebtedness to rest of the world:
$2.3 trillion---higher than any other country,
hence U.S. is “world’s largest debtor nation”

CHAPTER 5 The Open Economy slide 12

 Saving and Investment
in a Small Open Economy
 An open-economy version of the loanable
funds model from chapter 3.
 Includes many of the same elements:
production function: Y  Y  F (K , L )

consumption function: C  C (Y  T )

investment function: I  I (r )

exogenous policy variables: G  G , T  T

CHAPTER 5 The Open Economy slide 13

 National Saving:
The Supply of Loanable Funds

r S  Y  C (Y  T )  G

As in Chapter 3,
national saving does
not depend on the
interest rate

S S, I

CHAPTER 5 The Open Economy slide 14

 Assumptions re: capital flows
a. domestic & foreign bonds are perfect substitutes
(same risk, maturity, etc.)
b. perfect capital mobility:
no restrictions on international trade in assets
c. economy is small:
cannot affect the world interest rate, denoted r*

imply rr == r*
aa && bb imply r*
implies r*
cc implies r* isis 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 interest
rate would
adjust to
equate
investment
and saving: rc

I (r )

I (rc ) S, I
S
CHAPTER 5 The Open Economy slide 17
 But in a small open economy…
the exogenous r
S
world interest
rate determines
investment… NX
…and the r*
difference
between saving rc
and investment I (r )
determines net
capital outflows
I1 S, I
and net exports

CHAPTER 5 The Open Economy slide 18

 Three experiments
1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

CHAPTER 5 The Open Economy slide 19

 1. Fiscal policy at home
r S 2 S1
An increase in G
or decrease in T NX2
reduces saving. r *
1

NX1
Results:
I  0
NX  S  0 I (r )

I1 S, I

CHAPTER 5 The Open Economy slide 20

NX and the Government Budget Deficit
44 Budget deficit 88

GDP
GDP

ofGDP
ofGDP

33
(right scale) 66

Percentof
Percentof

Percent
Percent

22 44

11 22

00 00

-1
-1 -2
-2
-2
-2 -4
-4
-3
-3 Net exports -6
-6
(left scale)
-4
-4 -8
-8
-5
-5 -10
-10
1950
1950 1960
1960 1970
1970 1980
1980 1990
1990 2000
2000

CHAPTER 5 The Open Economy slide 21

 2. Fiscal policy abroad
r S1
Expansionary
NX2
fiscal policy
abroad raises r2*
NX1
the world
interest rate. r1
*

Results:
I  0 I (r )
NX  I  0
S, I
I (r )
2
*
I (r1* )

CHAPTER 5 The Open Economy slide 22

3. An increase in investment demand
r
S

r*
EXERCISE:
Use the model to NX1
determine the impact
of an increase in
investment demand I (r )1
on NX, S, I, and net
capital outflow. I1 S, I

CHAPTER 5 The Open Economy slide 23

3. An increase in investment demand
r
S
ANSWERS: NX2
I > 0, r*
S = 0,
net capital NX1
outflows and I (r )2
net exports
fall by the I (r )1
amount I
I1 I2 S, I

CHAPTER 5 The Open Economy slide 24

 The nominal exchange rate

e = nominal exchange rate,

the relative price of
domestic currency
in terms of foreign currency
(e.g. Yen per Dollar)

CHAPTER 5 The Open Economy slide 25

Exchange rates as of June 23, 2003

country exchange rate

Euro 0.86 Euro/$
Japan 117.5 Yen/$
Mexico 10.5 Pesos/$
Russia 30.4 Rubles/$
South Africa 7.9 Rand/$
Turkey 1,432,815.9 Liras/$
U.K. 0.60 Pounds/$

CHAPTER 5 The Open Economy slide 26

 The real exchange rate

ε = real exchange rate,

the relative price of
the lowercase domestic goods
Greek letter in terms of foreign goods
epsilon
(e.g. Japanese Big Macs per
U.S. Big Mac)

CHAPTER 5 The Open Economy slide 27

Understanding the units of ε
e P
ε 
P *
(Yen per $)  ($ per unit U.S. goods)

Yen per unit Japanese goods

Yen per unit U.S. goods


Yen per unit Japanese goods

Units of Japanese goods


per unit of U.S. goods

CHAPTER 5 The Open Economy slide 28

 ~ McZample ~
 one good: Big Mac
 price in Japan:
P* = 200 Yen
 price in USA:
P = $2.50
 nominal exchange rate
e = 120 Yen/$ To
Tobuy
buyaaU.S.
U.S.Big
BigMac,
Mac,
e P someone
someonefrom
fromJapan
Japan
ε  would
P* wouldhave
haveto topay
payan
an
120  $2.50 amount
amountthat
thatcould
couldbuy
buy
  1.5 1.5
200 Yen 1.5Japanese
JapaneseBigBigMacs.
Macs.

CHAPTER 5 The Open Economy slide 29

 ε in the real world & our model
 In the real world:
We can think of ε as the relative price of
a basket of domestic goods in terms of a
basket of foreign goods
 In our macro model:
There’s just one good, “output.”
So ε is the relative price of one country’s
output in terms of the other country’s output

CHAPTER 5 The Open Economy slide 30

 How NX depends on ε

ε  U.S. goods become more expensive

relative to foreign goods
 EX, IM
 NX

CHAPTER 5 The Open Economy slide 31

 U.S. Net Exports and the
Real Exchange Rate, 1975-2003
GDP

100
2% 140
ofGDP

1973:1==100
2% 140
1% 120
Percentof

1% 120

1973:1
Percent

0%
0% 100
100
-1%
-1% 80
80
-2%
-2% 60
60
-3%
-3% 40
40

-4%
-4% 20
20
-5%
-5% 00
1975
1975 1980
1980 1985
1985 1990
1990 1995
1995 2000
2000
Net
Netexports
exports(left
(leftscale)
scale)
Real
Realexchange
exchangeraterateindex
index(right
(rightscale)
scale)

CHAPTER 5 The Open Economy slide 32

 The net exports function
 The net exports function reflects this
inverse relationship between NX and ε:
NX = NX (ε )

CHAPTER 5 The Open Economy slide 33

 The NX curve for the U.S.

so U.S. net
When ε is exports will
relatively low,
U.S. goods are be high
ε1
relatively
inexpensive NX(ε)
0 NX
NX(ε1)
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(ε2) 0 NX

CHAPTER 5 The Open Economy slide 35

 How ε is determined
 The accounting identity says NX = S  I
 We saw earlier how S  I is determined:
• S depends on domestic factors (output,
fiscal policy variables, etc)
• I is determined by the world interest
rate r *
 So, ε must adjust to ensure
NX (ε )  S  I (r *)

CHAPTER 5 The Open Economy slide 36

 How ε is determined

Neither S nor I S 1  I (r *)
depend on ε, ε
so the net
capital outflow
curve is vertical.

ε1
ε adjusts to
equate NX NX(ε )
with net capital
outflow, S  I. NX
NX 1

CHAPTER 5 The Open Economy slide 37

 Interpretation: supply and demand in
the foreign exchange market
demand: S 1  I (r *)
Foreigners need ε
dollars to buy
U.S. net exports.

supply: ε1
The net capital
outflow (S  I ) NX(ε )
is the supply of
dollars to be NX
NX 1
invested abroad.

CHAPTER 5 The Open Economy slide 38

 Four experiments
1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

4. Trade policy to restrict imports

CHAPTER 5 The Open Economy slide 39

 1. Fiscal policy at home
A fiscal expansion
S 2  I (r *)
reduces national
saving, net capital ε S 1  I (r *)
outflows, and the
supply of dollars in ε2
the foreign
exchange market…
ε1

…causing the NX(ε )

real exchange
rate to rise and NX
NX 2 NX 1
NX to fall.
CHAPTER 5 The Open Economy slide 40
 2. Fiscal policy abroad

An increase in r* S 1  I (r1 *)
reduces investment, ε S 1  I (r2 *)
increasing net
capital outflows and ε
1
the supply of dollars
in the foreign
exchange market… ε 2

NX(ε )
…causing the
real exchange NX
rate to fall and NX 1 NX 2
NX to rise.
CHAPTER 5 The Open Economy slide 41
 3. An increase in investment demand

An increase in S1  I 2
investment ε S1  I 1
reduces net
capital outflows
ε2
and the supply
of dollars in the
foreign exchange ε1
market…
NX(ε )
…causing the
NX
real exchange NX 2 NX 1
rate to rise and
NX to fall.
CHAPTER 5 The Open Economy slide 42
 4. Trade policy to restrict imports

At any given value of

ε, an import quota ε S I
IM NX
demand for ε2
dollars shifts
right ε1
NX (ε )2
Trade policy doesn’t NX (ε )1
affect S or I , so
capital flows and the NX
NX1
supply of dollars
remains fixed.
CHAPTER 5 The Open Economy slide 43
 4. Trade policy to restrict imports

Results:
ε S I
ε > 0
(demand
increase) ε2
NX = 0
(supply fixed) ε1
IM < 0 NX (ε )2
(policy)
NX (ε )1
EX < 0
(rise in ε ) NX
NX1

CHAPTER 5 The Open Economy slide 44

 The Determinants of the
Nominal Exchange Rate
 Start with the expression for the real
exchange rate:
e P
ε 
P *

 Solve it for the nominal exchange rate:

P*
e  ε 
P

CHAPTER 5 The Open Economy slide 45

 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:

P*
e  ε 
P

CHAPTER 5 The Open Economy slide 46

 The Determinants of the
Nominal Exchange Rate
P*
e  ε 
P
 We can rewrite this equation in terms of
growth rates (see “arithmetic tricks for working
with percentage changes,” Chap 2 ):
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.

CHAPTER 5 The Open Economy slide 47

 Inflation and nominal exchange rates
Percentage 10
change
9
in nominal
exchange 8 South Africa
rate 7
6 Depreciation
5 Italy relative to
U.S. dollar
4 New Zealand
Australia Spain
3 Sweden
Ireland
2 Canada
1 France UK
Belgium
0
-1 Appreciation
Germany Netherlands
-2 relative to
Switzerland U.S. dollar
-3 Japan
-4
-3 -2 -1 0 1 2 3 4 5 6 7 8
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

CHAPTER 5 The Open Economy slide 49

 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.
CHAPTER 5 The Open Economy slide 50
 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
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. 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.
CHAPTER 5 The Open Economy slide 52
 CASE STUDY
The Reagan Deficits revisited
actual closed small open
1970s 1980s
change economy economy
G–T 2.2 3.9   
S 19.6 17.4   
r 1.1 6.3   no change
I 19.9 19.4   no change
NX -0.3 -2.0  no change 
ε 115.1 129.4  no change 
Data: decade averages; all except r and ε are expressed
as a percent of GDP; ε is a trade-weighted index.
CHAPTER 5 The Open Economy slide 53
The U.S. as a large open economy
 So far, we’ve learned long-run models for
two extreme cases:
 closed economy (chapter 3)
 small open economy (chapter 5)
 A large open economy --- like the U.S. --- is
in between these two extremes.
 The analysis of policies or other exogenous
changes in a large open economy is a mixture of
the results for the closed & small open economy
cases.
 For example…
CHAPTER 5 The Open Economy slide 54
 A fiscal expansion in three models
A fiscal expansion causes national saving to fall.
The effects of this depend on the degree of openness:
closed large open small open
economy economy economy
rises, but not as much no
r rises
as in closed economy change
falls, but not as much no
I falls
as in closed economy change
no falls, but not as much as
NX falls
change in small open economy

CHAPTER 5 The Open Economy slide 55

 Chapter summary
1. Net exports--the difference between
 exports and imports
 a country’s output (Y )
and its spending (C + I + G)
2. Net capital outflow equals
 purchases of foreign assets
minus foreign purchases of the country’s assets
 the difference between saving and investment
3. National income accounts identities:
 Y = C + I + G + NX
 trade balance NX = S  I net capital outflow

CHAPTER 5 The Open Economy slide 56

 Chapter summary
4. 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
5. 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.

CHAPTER 5 The Open Economy slide 57

 Chapter summary
6. How the real exchange rate is determined
 NX depends negatively on the real exchange
rate, other things equal
 The real exchange rate adjusts to equate
NX with net capital outflow
7. How the nominal exchange rate is determined
 e equals the real exchange rate times the
country’s price level relative to the foreign
price level.
 For a given value of the real exchange rate,
the percentage change in the nominal
exchange rate equals the difference between
the foreign & domestic inflation rates.
CHAPTER 5 The Open Economy slide 58
CHAPTER 5 The Open Economy slide 59