Until now: closed economy

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• Until now closed economy
• In reality, most economies are open
• - export goods and services abroad
• - import goods and services from
  abroad
• - borrow and lend in financial
  markets
• Some empirical evidence
• - in US, imports and exports are about 13 of
  GDP
• - in Canada and United Kingdom, imports and
  exports are over 30 of GDP
• - in Netherlands or Belgium (smaller
  countries), exports are more than 50 of GDP

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This part Open-Economy Macroeconomics

• 1) How to measure the interactions among
  countries (flows of goods and services and flows
  of funds)
• (the accounting identities)

• 2) The determinants of these international flows
• (a model of a small open economy)

3) Exchange rates (the prices at which a country
makes exchanges in the world markets)
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1. The international flows of capital and goods

• Closed economy
• - all output is sold domestically
• - expenditure is divided into
• consumption (C)
• investment (I)
• government purchases (G)

• Open economy
• - some output is sold domestically and some is
  exported to be sold abroad
• - expenditure is divided
• into
• consumption (Cd)
• investment (Id)
• government purchases (Gd)
• exports of domestic goods and services (EX)

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National Income Accounts Identity in an Open
Economy
Y C I G NX
Notice weve added net exports, NX, defined as
EX-IM. Also, note that domestic spending on all
goods and services is the sum of domestic
spending on domestic goods and services and on
foreign goods and services.
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Y C I G NX
After some manipulation, the national income
accounts identity can be re-written as
NX Y - (C I G)
This equation shows that in an open economy,
domestic spending need not equal the output of
goods and services. If output exceeds domestic
spending, we export the difference net exports
are positive. If output falls short of domestic
spending, we import the difference net exports
are negative.
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Net Foreign Investment the Trade Balance
Start with the national income accounts identity.
YCIGNX.
Subtract C and G from both sides and obtain Y-C-G
INX.
So, now we have SINX. Subtract I from both
sides to obtain the new equation, S-INX.
This form of the national income accounts
identity shows that an economys net exports
must always equal the difference between its
saving and its investment.
S-INX
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It reflects the international flow of funds to
finance capital accumulation
If S-I and NX are positive, we have a trade
surplus. We would be net lenders in world
financial markets, and we are exporting more
goods than we are importing. If S-I and NX are
negative, we have a trade deficit. We would be
net borrowers in world financial markets, and we
are importing more goods than we are
exporting. If S-I and NX are exactly zero, we
have balanced trade since the value of imports
equals the value of exports.
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2. Saving and Investment in a Small Open Economy
Until now, we have just defined some of the
variables that measure interactions among
countries. We are now going to develop a model
of the international flows of capital and goods,
that will explain the behavior of these
variables. Then, well address issues such as how
the trade balance responds to changes in policy.
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Capital Mobility and the World Interest Rate
- Well borrow a part of the model from Chapter
3, but wont assume that the real interest rate
equilibrates saving and investment. - Instead,
well allow the economy to run a trade deficit
and borrow from other countries, or to run a
trade surplus and lend to other
countries. Assumptions - Consider a small open
economy with perfect capital mobility, which it
takes the world interest rate r as given,
denoted r r. -Our small open economy takes
the world interest rate as an exogenously given
variable
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The Model
The economys output Y is fixed by the factors of
production and the production function.
Y Y F(K,L)
Consumption is positively related to disposable
income (Y-T).
C C (Y-T)
Investment is negatively related to the real
interest rate.
I I (r)
The national income accounts identity, expressed
in terms of saving and investment.
NX (Y-C-G) - I or NX S - I
Now substitute our three assumptions from Chapter
3 and the condition that the interest rate equals
the world interest rate, r.
NX (Y-C(Y-T) - G) - I (r)
NX S - I (r)
This equation suggests that the trade balance is
determined by the difference between saving and
investment at the world interest rate.
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Saving and Investment in a Small Open Economy
In this case, since r is above rclosed and
saving exceeds investment, there is a trade
surplus (SgtI).
If the world interest rate decreased to r ', I
would exceed S and there would be a trade
deficit (SltI).
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How Policies Influence the Trade Balance?
The impact of economic policies on the trade
balance the impact of economic
policies on domestic saving and domestic
investment. We will consider the following three
situations - a domestic fiscal expansion - a
fiscal expansion abroad - a shift in the
investment demand
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A Domestic Fiscal Expansion in a Small Open
Economy
Suppose the economy begins in a position of
balanced trade. An increase in (domestic)
government purchases or a cut in taxes decreases
national saving and thus shifts the national
saving schedule to the left.
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A Fiscal Expansion Abroad in a Small Open Economy
What happens to a small open economy when foreign
governments increase their government purchases?
- If these countries are large enough to
influence world saving and investment then the
world interest rate raises from r1 to r2.
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A Shift in the Investment Schedule in a Small
Open Economy
An outward shift in the investment schedule from
I(r)1 to I(r)2 increases the amount of
investment at the world interest rate r.
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To summarize

• Policies that decrease saving or increase
  investment tend to cause a trade deficit
• Policies that increase saving or decrease
  investment tend to cause a trade surplus

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3. Exchange rates
In the next few slides, well learn about the
foreign exchange market, exchange rates and much
more!
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The Mechanics of the Foreign Exchange Market
- two countries (US and Japan) engage in trade
different cultures, languages, and currencies,
all of which could hinder trade. - because of
the foreign exchange market, trade transactions
become more efficient. - The foreign exchange
market is a global market in which banks are
connected through high-tech telecommunications
systems in order to purchase currencies for their
customers.
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In order for the U.S to pay for its imports of
goods and services and securities from Japan,
The Foreign Exchange Market
it must supply dollars which are then converted
into yen by the foreign exchange
market.
Foreign Exchange Market
In order for Japan to pay for its imports of
goods and services and securities from the U.S.,
it must supply yen which are then
converted into dollars by the foreign exchange
market.
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The exchange rate between two countries is the
price at which residents of those countries trade
with each other.
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Nominal Exchange Rate, e
The nominal exchange rate is the relative price
of the currency of two countries. For example,
if the exchange rate between the U.S. dollar and
the Japanese yen is 120 yen per dollar, then you
can exchange 1 dollar for 120 yen in world
markets for foreign currency. A Japanese who
wants to obtain dollars would pay 120 yen for
each dollar he bought. An American who wants to
obtain yen would get 120 yen for each dollar he
paid. When people refer to the exchange rate
between two countries, they usually mean the
nominal exchange rate.
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The real exchange rate is the relative price of
the goods of two countries. The real exchange
rate tells us the rate at which we can trade the
goods of one country for the goods of
another. The difference between the real and
nominal exchange rates - consider a single good
produced in many countries cars. -suppose an
American car costs 10,000 and a similar Japanese
car costs 2,400,000 yen. - if a dollar is worth
120 yen, then the American car costs 1,200,000
yen. - Comparing the price of the American car
(1,200,000 yen) and the price of the Japanese car
(2,400,000 yen), we conclude that the American
car costs one-half of what the Japanese car
costs. - In other words, at current prices, we
can exchange 2 American cars for 1 Japanese car.
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We can summarize our calculation as follows Real
Exchange Rate (120 yen/dollar) ? (10,000
dollars/American car) (2,400,000 yen/Japanese
Car) 0.5 Japanese Car
American Car At these prices, and this exchange
rate, we obtain one-half of a Japanese car per
American car. More generally, we can write this
calculation as Real Exchange Rate Nominal
Exchange Rate ? Price of Domestic Good
Price of Foreign Good The rate
at which we exchange foreign and domestic goods
depends on the prices of the goods in the local
currencies and on the rate at which the
currencies are exchanged.
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Relationship between the real and nominal
exchange rate
e e (P/P)
Nominal Exchange Rate
Ratio of Price Levels
Real Exchange Rate
Note P is the price level of the domestic
country (measured in the domestic currency) and
P is the price level of the foreign country
(measured in the foreign currency).
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e e (P/P)
Real Exchange Rate
Nominal Exchange Rate
Ratio of Price Levels
The real exchange rate between two countries is
computed from the nominal exchange rate and the
price levels in the two countries. If the real
exchange rate is high, foreign goods are
relatively cheap, and domestic goods are
relatively expensive. If the real exchange rate
is low, foreign goods are relatively expensive,
and domestic goods are relatively cheap.
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The Real Exchange Rate and the Trade Balance
The relationship between the real exchange rate
and net exports is negative the lower the real
exchange rate, the less expensive are domestic
goods relative to foreign goods, and thus the
greater are our net exports.
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The Impact of Expansionary Fiscal Policy at Home
on the Real Exchange Rate
S2-I
Expansionary fiscal policy at home, such as
an increase in government purchases G or a cut
in taxes, reduces national saving.
e2
e1
NX(e)
NX2
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The Impact of Expansionary Fiscal Policy Abroad
on the Real Exchange Rate
Expansionary fiscal policy abroad reduces world
saving and raises the world interest rate from
r1 to r2.
S-I(r1)
e1
As a result, the equilibrium real exchange rate
falls from e1 to e2.
e2
NX1
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The Impact of an Increase in Investment Demand on
the Real Exchange Rate
An increase in investment demand raises the
quantity of domestic investment from I1 to I2.
S-I2
e2
This fall in supply raises the equilibrium real
exchange rate from e1 to e2.
e1
NX2
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Purchasing Power Parity
The law of one price - the same good cannot sell
for different prices in different locations at
the same time
Purchasing Power Parity - the law of one price
applied to the international market place - It
states that if international arbitrage is
possible, then a dollar must have the same
purchasing power in every country. - Purchasing
Power Parity does not always hold because some
goods are not easily traded, and sometimes traded
goods are not always perfect substitutes but it
does give us reason to expect that fluctuations
in the real exchange rate will be small and
short-lived.
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Purchasing Power Parity
The law of one price applied to the
international marketplace suggests that net
exports are highly sensitive to small movements
in the real exchange rate. This high sensitivity
is reflected here with a very flat net-exports
schedule.
Real exchange rate, e
S-I
NX(e)
Net Exports, NX
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Key Concepts of Ch. 8
Net exports Trade balance Net capital
outflow Trade surplus and trade deficit Balanced
trade Small open economy World interest
rate Nominal exchange rate Real exchange
rate Purchasing-power parity