Chapter Four

Aggregate Demand in Open Economy

Compiled By: Zenawi B.

• The key difference between open and closed
economy is,
– in open economy country’s spending need not
equal with country output of goods and services.
• A country could spend more(by borrowing) or
less by (by lending) what it produces.
The role of Net Export
• In closed economy, expenditure on economies
out put is divided in to components of
consumption, investment and gov’t purchase.
• In open economy expenditure on economies
out is divided on components of ;
 – Cd = consumption of domestic goods and services
– Id= investment of domestic goods and services
– Gd= government purchase of domestic goods and
services
– X= export of domestic goods and services.
• Hene, Y = Cd + Id + Gd + X
• BUT, expenditure on all goods and services
equals expenditure on domestic goods plus
expenditure on foreign goods.
• i.e C = Cd + Cf
I = Id + If
G = Gd + Gf
• If we substitute in to the above identity;
Y = (C- Cf) + (I – If) + ( G – Gf) + X
Y = C + I + G + X – ( Cf + If + Gf )

is Expenditure on import
Y = C + I + G + X – IM
• X – IM is Net export.
• Y = C + I + G + Nx this equation tell us that
expenditure on domestic out put is the sum of
consumption, investment, gov’t purchase and
net export.
• NX = Y- (C + I + G)
• NX = Out put – domestic spending
• If out put > DS we Export the difference
• If out put < DS we Import the difference
International capital flow and trade balance
• financial markets are closely related to goods
market.
• To see their relationship, lets rewrite the
national income identity in terms of saving and
investment.
• Y = C + I + G + NX
• Y - C - G = I + NX
• S = I + NX
• NX = S - I
Called net capital outflow

Called trade balance

• If net capital out flow is negative, I > S, thus
the economy is experiencing capital inflow
and investment is financed by borrowing from
abroad.
• If net capital out flow is positive, S > I, and the
economy is lending to foreigners.
• If NX is positive, we have trade surplus
exporting more goods than import and net
lenders in financial market.
• If NX is negative, we have trade deficit
exporting less goods than import and net
borrowers in financial market.
• In conclusion, trade balance and international flow of
funds or capital are two sides of the same coin.
Trade surplus Balanced trade Trade deficit
EX > IM EX = IM EX < IM
NX > 0 NX = 0 NX < 0
S>I S=I S<I
Y > C+I+G Y = C+I+G Y < C+I+G
Net capital outflow > 0 Net capital outflow = 0 Net capital outflow < 0
 4.2 saving and investment in small open
Economy
• Small economy here is to mean an economy
that has negligible effect on world economy
and interest rate.
• The small open economy is assumed to have
perfect factor mobility. Implying;
– residents have full access to world financial
market
– The government does not impede international
borrowing and lending.
• Interest rate in small economy (r) is
determined by world interest rate (r*).
• r = r*
• Domestic residents does not borrow above r* because
they can get loan at r* from abroad.
• Domestic residents does not lent below r* because
they can earn r*by lending abroad.
THE MODEL
• Economies out put (Y) is given by:
Y = Y =f( k,L)
• Consumption is function of disposable income
C= c(Y-T)
• Investment is negatively related with interest rate
I = I(r)
• Hence, we have Y= C+I+G+NX
NX = (Y-C-G)- I
NX = S – I(r*)
• NX depends on factors that determine saving
and investment.
• Saving depends on G and T whereas
investment on r*.
r* s
• Graphically;

r
I (r*)

Interest rate if the

I,S
economy were closed
 How policies affect trade balance
1. Fiscal policy at home
• 1. Government purchase-
2. Increase in G reduces Saving and S
r*
shift to left
S2 S1
1. The Economy begins in balanced
trade

A Fiscal Expansion at Home in a Small

Open Economy An increase in government
r* purchases or a reduction in taxes reduces
I(r)
NX national saving and thus shifts the saving
schedule to the left, from S1 to S2. The
Saving, investment result is a trade deficit.

3. Causes trade deficit

 2. Fiscal policy abroad
• 1. Government purchase- if the economy in abroad is large,
increase in government purchase reduces world saving
• Reduction in world saving increases world interest rate
• increases world interest rate create trade surplus in small open
economy.
r* 2. Increase In r* reduces
NX> 0 S
investment and creates surplus
r2*

A Fiscal Expansion Abroad in a Small

r1* Open Economy A fiscal expansion in a
I(r*) foreign economy large enough to
influence world saving and investment
raises the world interest rate from r1 *
1. R to r2 *. The higher world interest rate
e
wor ductio reduces investment in this small open
l n Saving , investment
incr d savin in economy, causing a trade surplus.
ease g
r 1*
to r
 3. Shift in investment demand
• What happens to NX when I increases?

r*
S 1. increase in investment
demand

NX< 0
I2(r*) A Shift in the Investment Schedule in a
r*
I1(r*) Small Open Economy An outward shift
in the investment schedule from I(r)1 to
Saving, investment I(r)2 increases the amount of investment at
the world interest rate r*. As a result,
investment now exceeds saving, which
2. …. Leads to trade deficit
means the economy is borrowing from
abroad and running a trade deficit.
 Exchange Rate
• Exchange rate is of two types nominal and real.
• Nominal exchange rate: is relative price of
currencies of two countries.
• E.g: 30 birr/$( exchange rate b/n Us dollar and
Ethiopian birr).
• When people refer to exchange rate b/n two
countries they usually mean nominal exchange
rate.
• Exchange rate can be reported in two ways;
– Domestic currency per foreign ( birr/dollar)
– Foreign currency per domestic (dollar/birr)
• Through out this chapter we are going to use
dollar/birr.
• Real Exchange rate: is relative price of goods
of two countries.
• It tell us the rate at which the good of one
country is traded for another.
• It is also called term of trade ( TOT).
• Example: suppose an American car costs
$10,000 and similar Ethiopian car costs birr
2,400,00. compare the cost?(exchange rate
=30 birr/dollar.)
• To compare the cost, we have to convert in to
similar currency.
• American car costs 10,000 $ * 30 birr/$
=300,000 birr
• Ethiopian car costs 2,400,000 birr. Therefore,
Ethiopian car costs 8 times of what American
car costs.
•At current market price 8 American cars are exchanged for one Ethiopian car.
• High real exchange rate implies foreign goods are cheap and domestic goods are
relatively expensive.
•Low real exchange rate implies foreign goods are expensive and domestic goods are
relatively cheap.

The real exchange rate and trade balance

•Real exchange rate(E) determines which countries product to choose by consumers.
•If Real exchange rate(E) is high, domestic goods are expensive relative to foreign
goods therefore; domestic residents purchase more imported goods
• Foreigners will purchase less of less of our(imported) goods
• This lowers net export.
•NX = NX(E) net export depends on real exchange rate and they are inversely
related.
 Real Exchange rate ( E)

NX

Net export NX
• The trade balance (Nx) must be equal to capital outflow,
which in turn equals saving minus investment.
• Saving is determined by income consumption, and fiscal
polices.
• Investment is determined by world interest rate (r*).
• Nx = S-I
• The graph S- I, becomes vertical b/c neither S nor I depends
on exchange rate.
 • Real Exchange Rate (E) S–I

Eq
exc uilibr
han ium
ge r NX
rat eal
e
NX

• S- I denotes supply of birr in world financial market and NX denotes

demand for birr in world financial market.
• At the equilibrium real exchange rate, the supply of birr available from the
net capital outflow balances the demand for birr by foreigners buying our
net exports.
How Policies Influence the Real Exchange Rate
• Fiscal Policy at Home : What happens to the real exchange rate if the
government reduces national saving by increasing government purchases
or cutting taxes? As we discussed earlier, this reduction in saving lowers
S – I and thus NX. That is, the reduction in saving causes a trade deficit.
Real exchange rate (E)
S2 - I S1 - I

E2

E1
NX2 NX1 NX