6

CHAPTER

The Open Economy

MACROECONOMICS
N. GREGORY MANKIW
 Trade-GDP ratio, selected countries, 2004
(Imports + Exports) as a percentage of GDP

Luxembourg 275.5% Germany 71.1%

Ireland 150.9 Turkey 63.6
Czech Republic 143.0 Mexico 61.2
Hungary 134.5 Spain 55.6
Austria 97.1 United Kingdom 53.8
Switzerland 85.1 France 51.7
Sweden 83.8 Italy 50.0
Korea, Republic of 83.7 Australia 39.6
Poland 80.0 United States 25.4
Canada 73.1 Japan 24.4

CHAPTER 5 The Open Economy slide 3

 In an open economy,

 spending need not equal output

 saving need not equal investment

See Supplements 5-1, Terminology of Trade, and

5-2, Saving-Investment in Open Economies.

CHAPTER 5 The Open Economy slide 4

 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 6

 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 7

 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 8

 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 10

 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 11

 Understanding the units of ε
P
𝜺=𝒆 × ∗
𝑷
Price  of Domestic Durrency in  Foreign  Currency Price od Domestic Goods  in Domestic Currency
¿ ×
Price  of Domestic Currency in  Domestic Currency Price of  Foreign  Goods  in Foreign Currency
Foreign  Currency / unit  Domestic  Currency Domestic  Currency / unit  Domestic  Goods
¿ ×
Domestic  Currency / unit  Domestic  Currency Foreign  Currency / unit  Foreign Goods
Foreign   Currency  /  unit   Domestic   Goods
¿
Foreign   Currency  /  unit   Foreign  Goods
unit s   of   Foreign   Goods
¿
per   unit   Domestic   Goods
CHAPTER 5 The Open Economy slide 12
 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 14

 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 15

 U.S. net exports and the
real exchange rate, 1973-2006
3% Trade-weighted real 140
2% exchange rate index
120
1%

Index (March 1973 = 100)

0% 100
NX (% of GDP)

-1%
80
-2%
60
-3%
-4% 40
Net exports
-5% (left scale)
20
-6%
-7% 0
1973 1977 1981 1985 1989 1993 1997 2001 2005
CHAPTER 5 The Open Economy slide 16
 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 17

 The NX curve for the U.S.
ε

so U.S. net
When ε is exports will
relatively low, be high
U.S. goods are
relatively ε1
inexpensive
NX
(ε)
0
NX(ε1) NX
CHAPTER 5 The Open Economy slide 18
 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 19