National Income Accounts Identity in an Open Economy

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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 domestics 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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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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Saving and Investment in a Small Open Economy
We are now going to develop a model of the
international flows of capital and goods. 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
Recall that the trade balance equals the net
capital outflow, which in turn equals saving
minus investment, our model focuses on saving and
investment. 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. Consider a small open economy with
perfect capital mobility in which it takes the
world interest rate r as given, denoted r
r. Remember in a closed economy, what
determines the interest rate is the equilibrium
of domestic saving and investment--and in a way,
the world is like a closed economy-- therefore
the equilibrium of world saving and world
investment determines the world interest rate.
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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.
If the world interest rate decreased to r ', I
would exceed S and there would be a trade
deficit.
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A Domestic Fiscal Expansion in a Small Open
Economy
An increase in 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
A fiscal expansion in a foreign economy large
enough to influence world saving and investment
raises the world interest rate 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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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
Lets think about when the US and Japan engage in
trade. Each country has different cultures,
languages, and currencies, all of which could
hinder trade. But, 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. The next slide is a graphical
representation of the flow of the trade between
the U.S. and Japan, and how the mix of traded
things might be different, but is always
balanced. Also, notice how the foreign exchange
market will play the middle-man in these
transactions. For instance, the foreign exchange
market converts the supply of dollars from the
U.S. into the demand for yen, and conversely, the
supply of yen into the demand for dollars.
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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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Appreciation and Depreciation
Suppose that there is an increase in the demand
for U.S. goods and services. How will this affect
the nominal exchange rate?
D shifts rightward and increases the nominal
exchange rate, e. This is known as appreciation
of the dollar.
Events which decrease the demand for the dollar,
and thus decrease e would be a depreciation of
the dollar.
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The real exchange rate is the relative price of
the goods of two countries. That is, the real
exchange rate tells us the rate at which we can
trade the goods of one country for the goods of
another. To see 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. To compare the
prices of the two cars, we must convert them
into a common currency. 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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Purchasing Power Parity
How does the level of prices effect exchange
rates? It doesnt. All changes in a nations
price level will be fully incorporated into the
nominal exchange rate. It is the law of one price
applied to the international marketplace.
Purchasing Power Parity suggests that nominal
exchange rate movements primarily reflect
differences in price levels of nations. 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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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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Key Concepts of Ch. 5
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