Chapter 5: open economy
 accounting identities for the open economy
 small open economy model
 what makes it “small”
 how the trade balance and exchange rate are
determined and affected by policy
 In an open economy, spending =/= output
CHAPTER 5
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The Open Economy
GDP = expenditure on
domestically produced g & s
Domestic economy : Y = C + I + G
Open economy: Y = CD + ID + GD + EX
IM = CF + IF + GF
EX – IM = NX = net exports ( “trade balance”)
C = CD + CF
I = I D + IF
G = GD + G F
Y = C + I + G + EX – IM = C + I + G + NX
CHAPTER 5
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The Open Economy
The income identity in an open economy and
International capital flows
Goods markets
Y = C + I + G + NX
NX = Y – (C + I + G)
Financial markets
NX = (Y – C – G) – I = S – I
net outflow of goods = net purchases of foreign assets
S>I international lender, S<I international borrower
CHAPTER 5
The Open Economy
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1
Saving and Investment
in a Small Open Economy
 Open-economy version loanable funds model.
 Key elements:
production function:
consumption function:
Y  Y  F (K , L )
C  C (Y  T )
I  I (r )
investment function:
exogenous policy variables: G  G , T  T
CHAPTER 5
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The Open Economy
Assumptions about 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*
A and B  r = r*
C  r* exogenous
CHAPTER 5
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The Open Economy
Investment and saving
r
S  Y  C (Y  T )  G
NX
r*
rc
I (r )
I1
CHAPTER 5
The Open Economy
S, I
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2
Experiment 1: Fiscal policy at home
r
S 2 S1
An increase in G
reduces saving.
NX2
r1*
NX1
Results:
I  0
I (r )
NX  S  0
S, I
I1
CHAPTER 5
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The Open Economy
2. Fiscal policy abroad
r
Expansionary
fiscal policy
abroad raises
the world
interest rate.
NX2
r2*
S1
NX1
r1*
Results:
I  0
I (r )
NX  I  0
I (r1* )
I (r2* )
CHAPTER 5
S, I
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The Open Economy
The nominal exchange rate
e = nominal exchange rate,
the relative price of one currency in
terms of the other
country
exchange rates
Euro
1.46 $/Euro (0.68 Euro/$)
Japan
90 Yen/$
Beware of the conventions!
Euro: we normally quote dollar vs euro
Yen: we normally quote yen vs dollar
CHAPTER 5
The Open Economy
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The real exchange rate
= real exchange rate,
relative price of domestic goods in terms of foreign goods
e P
(Yen per $)  ($ per unit U.S. goods)

P*
Yen per unit Japanese goods
ε 
CHAPTER 5

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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The Open Economy
~ example 1 ~
 one good: Big Mac
 price in Japan:
P* = 280 Yen
 price in USA:
P = $3.50
 nominal exchange
This example:
ε>1
Goods in US are ``more
expensive” than in Japan
Dollar is overvalued wrt
yen
rate
e = 90 Yen/$
ε =90 x 3.50 / 280 = 1.125
CHAPTER 5
Would need 80 Yen/$ to
restore PPP.
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The Open Economy
~ example 2 ~
 one good: Kindle (from
Amazon.com, .de)
 price in Euro Area:
P* = 270 euros
 price in USA:
P = 300 dollars
 nominal exchange rate
This example:
ε<1
Goods in US are ``less
expensive” than in the Euro
area (25% cheaper)
e = 0.68 Euro/$
ε =0.68 x 300 / 270 = 0.75
CHAPTER 5
The Open Economy
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How NX depends on ε
ε  U.S. goods become more expensive
relative to foreign goods
 EX, IM
 NX
 The net exports function :
NX = NX (ε )
CHAPTER 5
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The Open Economy
How ε is determined
 NX = S  I
• S depends on domestic factors (output,
fiscal policy variables, etc)
• I is determined by the world interest
rate r *
 ε must adjust to ensure
NX (ε )  S  I (r *)
CHAPTER 5
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The Open Economy
How ε is determined
ε
S 1  I (r *)
ε1
NX(ε )
NX 1
CHAPTER 5
The Open Economy
NX
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5
Exp 1. Fiscal policy at home
S 2  I (r *)
ε
S 1  I (r *)
ε2
ε1
NX(ε )
CHAPTER 5
NX
NX 1
NX 2
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The Open Economy
Exp. 2. Fiscal policy abroad
S 1  I (r1 *)
ε
S 1  I (r 2 * )
ε1
ε2
NX(ε )
NX 1
CHAPTER 5
NX 2
NX
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The Open Economy
From real to nominal variables:
Nominal Exchange Rate determination
 Real exchange rate:  e P / P*
 Solve for nominal exchange rate:
e  ε 
P*
P
M
 L (r *   ,Y )
P
N X (ε )  S  I (r *)
e
e
CHAPTER 5

ε
ε

P *
P*
The Open Economy

P
P
M*
 L * (r *  *,Y * )
P*

ε
ε
 *  
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Inflation and nominal exchange rates
Percentage 10
change
9
in nominal
exchange 8
rate
7
6
5
4
3
2
1
South Africa
New Zealand
Australia
Spain
Sweden
Ireland
Canada
UK
France
Belgium
0
-1
Germany
Netherlands
-2
Switzerland
-3
Japan
-4
-3
-2
-1
0
CHAPTER 5
Depreciation
relative to
U.S. dollar
Italy
Appreciation
relative to
U.S. dollar
1
2
3
4
5
6
7
8
Inflation differential
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The Open Economy
Purchasing Power Parity (PPP)
goods must sell at the same (currency adjusted)
price in all countries.
e P = P*
 PPP:
ε e
CHAPTER 5
P
P* P


1
*
P
P P*
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The Open Economy
Purchasing Power Parity (PPP)
 If e = P*/P,
then
and the NX curve is horizontal:
ε
ε =1
S I
NX
Under PPP, changes
in (S  I ) have no
impact on ε or e.
NX
CHAPTER 5
The Open Economy
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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. Goods in different locations are not perfect
substitutes.
CHAPTER 5
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The Open Economy
US: large open economy
A FISCAL EXPANSION causes national saving to fall.
The effects of this depend on the degree of openness:
closed
economy
large open
economy
small open
economy
r
rises
rises, but not as much
as in closed economy
no
change
I
falls
falls, but not as much
as in closed economy
no
change
NX
no
change
falls, but not as much as
in small open economy
falls
CHAPTER 5
The Open Economy
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