Chapter 6

The Open Economy

Modified by Yun Wang
Eco 3203 Intermediate Macroeconomics
Florida International University
Summer 2017
© 2016 Worth Publishers, all rights reserved
In this chapter, you will learn…
• accounting identities for the open economy
• the small open economy model
• what makes it “small”
• how the trade balance and exchange rate are determined
• how policies affect trade balance & exchange rate

2
 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

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

4
 Preliminaries
superscripts:
C C d
C f
d = spending on
domestic goods
I I d
I f
f = spending on
G G G d f 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

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GDP = expenditure on
domestically produced g & s

Y  C d  I d  G d  EX
 (C  C )  (I  I )  (G  G )  EX
f f f

 C  I  G  EX  (C f  I f  G f )

 C  I  G  EX  IM

 C  I  G  NX

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The national income identity
in an open economy

Y = C + I + G + NX

or, NX = Y – (C + I + G )

domestic
spending
net exports
output

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 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

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U.S. net exports, 1950-2006

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 International capital flows
• Net capital outflow
=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

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 The link between trade & cap. flows

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

Thus,
a country with a trade deficit (NX < 0)
is a net borrower (S < I ).
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 “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 12/31/2005:
• U.S. residents owned $10.0 trillion worth of foreign assets
• Foreigners owned $12.7 trillion worth of U.S. assets
• U.S. net indebtedness to rest of the world:
$2.7 trillion--higher than any other country, hence U.S. is the
“world’s largest debtor nation”

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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
• consumption function Y  Y  F (K , L )
• investment function C  C (Y  T )
• exogenous policy variables
I  I (r )
G  G , T T

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 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
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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*

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 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
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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
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 But in a small open economy…
r
the exogenous S
world interest
rate determines
investment… NX
r*
…and the
difference rc
between saving
and investment I (r )
determines net
capital outflow I1 S, I
and net exports
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Next, three experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand

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 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

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 NX and the federal budget deficit
(% of GDP), 1960-2006
4% 8%
Budget deficit
2% (right scale) 6%

4%
0%
2%
-2%
0%

-4% Net exports -2%

(left scale)
-6% -4%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
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 2. Fiscal policy abroad
r S1
Expansionary
NX2
fiscal policy
abroad raises r2*
the world NX1
interest rate. r1
*

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

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 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

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

I1 I2 S, I

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The nominal exchange rate

e = nominal exchange rate,

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

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A few exchange rates, as of 7/14/06
country exchange rate
Euro 0.79 Euro/$
Indonesia 9,105 Rupiahs/$
Japan 116.3 Yen/$
Mexico 11.0 Pesos/$
Russia 27.0 Rubles/$
South Africa 7.2 Rand/$
U.K. 0.54 Pounds/$

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 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)

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 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

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~ McZample ~
• one good: Big Mac
• price in Japan:
P* = 200 Yen
• price in USA:
P = $2.50
• nominal exchange rate
e = 120 Yen/$
To buy a U.S. Big Mac,
e P someone from Japan
ε  would have to pay an
P *
120  $2.50 amount that could buy
  1 .5 1.5 Japanese Big Macs.
200 Yen
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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

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How NX depends on ε

ε  U.S. goods become more expensive relative to

foreign goods
 EX, IM
 NX

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 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
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 The net exports function

• The net exports function reflects this inverse

relationship between NX and ε :

NX = NX(ε )

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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
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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
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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 *)
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How ε is determined
Neither S nor I
depend on ε, ε S 1  I (r *)
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

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 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
Net capital
outflow (S  I ) NX(ε )
is the supply of
NX
dollars to be NX 1
invested abroad.
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Next, four experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
4. Trade policy to restrict imports

39
 1. Fiscal policy at home
A fiscal expansion S 2  I (r *)
reduces national ε S 1  I (r *)
saving, net capital
outflow, and the
supply of dollars ε2
in the foreign
exchange market…
ε1

NX(ε )
…causing the real
NX
exchange rate to NX 2 NX 1
rise and NX to fall.
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 2. Fiscal policy abroad
An increase in r*
S 1  I (r1 *)
reduces
investment, ε S 1  I (r 2 * )
increasing net
capital outflow and
ε1
the supply of
dollars in the
foreign exchange ε2
market…
NX(ε )

…causing the real NX

NX 1 NX 2
exchange rate to fall
and NX to rise.
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 3. Increase in investment demand
An increase in S1  I 2
investment
reduces net capital ε S1  I1
outflow and the
supply ε2
of dollars in the
foreign exchange
market… ε1

NX(ε )
…causing the
real exchange NX
NX 2 NX 1
rate to rise and
NX to fall.
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 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
remain fixed.
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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

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The determinants of the
nominal exchange rate
• Start with the expression for the real exchange rate:
e P
ε 
P*
§ Solve for the nominal exchange rate:
P*
e  ε 
P

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:
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
• Rewrite this equation in 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.
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Inflation differentials and nominal exchange rates

Mexico

Iceland

Singapore
South Africa
Canada
South Korea

U.K.
Japan

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

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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.
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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
ε =1 NX impact on ε or e.

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. Different countries’ goods not perfect substitutes.

• Nonetheless, PPP is a useful theory:

• It’s simple & intuitive
• In the real world, nominal exchange rates
tend toward their PPP values over the long run.

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 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.
The U.S. as a large open economy
• So far, we’ve learned long-run models for
two extreme cases:
• closed economy (chap. 3)
• small open economy (chap. 5)
• A large open economy – like the U.S. – falls
between these two extremes.
• The results from large open economy analysis
are a mixture of the results for the
closed & small open economy cases.
• For example…

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A fiscal expansion in three models
A fiscal expansion causes national saving to fall.
The effects of this depend on openness & size:
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
• Net exports--the difference between
• exports and imports
• a country’s output (Y )
and its spending (C + I + G)
• Net capital outflow equals
• purchases of foreign assets
minus foreign purchases of the country’s assets
• the difference between saving and investment

56
• National income accounts identities:
• Y = C + I + G + NX
• trade balance NX = S  I net capital outflow

• 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

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• 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.

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• 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

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• 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.

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