MACROECONOMICS
Chapter 5
The Open Economy
2
www.Wikipedia.org
Imports and Exports
As a Fraction of GDP
50%
45%
Percentage of GDP
40%
35%
30%
25%
20%
15%
10%
5%
0%
Canada
imports
France
Germany
Italy
Japan
Mexico
UK
US
exports
Imports and exports as a percentage of GDP by country, 2000. Source: OECD
3
Trade Balance ≈ Capital Flows
Y  C  I  G  NX
Y  C  T  S HH
T  S HH  I  G  NX
T G  S
HH
 I  NX
S GOV  S HH  I  NX
S  I  NX
I  S   NX
A positive trade balance (trade surplus)
happens when national saving exceeds
investments. A trade deficit indicates
that investments are greater than national
savings.
A trade surplus means there is a capital
outflow. A trade deficit means there is a
capital inflow.
If domestic spending (C+I+G) is less than
the GDP (Y), then net exports will be
positive. If domestic spending exceeds Y
then there will be a trade deficit.
4
US Current Account and
Net Foreign Wealth, 1977–2003
5
http://www.clevelandfed.org/research/trend
s/2009/0909/ET_sep09.pdf p.9
6
7
Why NX is Capital Outflow?

You import a DVD of Japanese anime by
using your debit card.
The Japanese producer of anime deposits the
funds in its bank account in San Francisco. The
bank credits the account by the amount of the
deposit. (Capital inflow = -NX)
A tourist from Detroit buys a meal in France and
pays with a traveler’s check. (Capital inflow = -NX)
An Italian buys a Dell computer and pays by a
credit card issued by an Italian bank. (Capital
outflow = NX)



8
Is US a Small Country?



US has the largest GDP in the world with onefifth of the income, one-seventh of the imports,
and one tenth of the exports of the world.
A large country is one that can affect export or
import prices by its supply or demand. Most
economists assume that is true of US.
Using an industrial organization approach,
Christopher Magee and Stephen Magee
(Review of International Economics, 16(5), 9901004, 2008) show that US is a small country.
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Smallness and Capital Flows
If capital markets in the world are free then
any one can borrow in the world market
and any one can lend in the world market.
 If borrowers or lenders (however they are
categorized) are small, then the world real
interest rate will equate the demand and
supply of loanable funds in the world.
 World saving=World investment and r=r*

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S, I, NX in Small Open Economies





Circular flow makes GDP=Income.
This equality shows that national saving will be equal to
investment plus net exports. Or national saving minus
investment equals net exports.
In the classical approach, labor and capital markets are
in equilibrium (no unemployment) so the K and L are
given in the production function, which makes Y fixed.
Since consumption is determined through Y, once Y is
fixed so is C and SHH.
If investments are determined by r*, then the difference
between S and I will be NX.
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GDP
HOUSEHOLDS
FIRMS
Y=wages+salaries+rent+profits+interest
C
IM
EX
FINANCIAL SYSTEM
I
T
TR+INT
REST OF THE WORLD
GOVERNMENT
G
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S, I, and NX
S
r
r***
r**
r*
S-I=NX gets different values for
different real interest rate for the
world. At r** the interest rate
would be the same as the closed
economy interest rate.
NX>0
NX=0
NX<0
I
I,S
What would happen to this diagram (1) when expansionary fiscal policy is pursued?
(2) when new savings enter the world capital markets? (3) when investment at home
increases? (4) when world investment increases?
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Is Trade Deficit Bad?
If it is the result of low national savings,
then the future generations will have to
pay in lower consumption.
 If it is the result of high investment, future
income will be higher to compensate for
the interest on the debt.

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Why Doesn’t Capital Flow to
Poor Countries?
MPK is higher when K is lower.
 But poor countries might have other
limitations reducing A, hence lowering Y.

Infrastructure
 Court system
 Corruption
 Undefined, unreliable property rights

15
Exchange Rate
Nominal Exchange Rate ¥/$ or $/€
 Real Exchange Rate

(¥/$)(PUS/PJ)
 ($/€)(PEU/PUS)

ε = e (P/P*)
Suppose 100 ¥=1$, 2$=1€, an average
American car is $20,000, Japanese car is
¥1,000,000, German car is €15,000.
 The meaning of Real Exchange Rate in
terms of cars; in general.

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NX and ε
When the real exchange rate (ε) is high
domestic goods are more expensive
compared to foreign goods. NX goes
down.
ε
 NX = NX (ε)


ε = (EUR/USD)(Pus/Peu)
0
NX
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Determination of ε
S-I<0
ε
S-I=0
S-I>0
NX(ε)
-NX
0
+NX
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Policies and ε

Expansionary fiscal policy at home


Expansionary fiscal policy abroad


World savings down => r* up => S-I up => ε down =>
NX up
Investment tax credit at home


S down => r up => ε up => NX down
I up => r up => ε up => NX down
Protectionist policies

NX shifts right (more NX at same ε) => ε up but no
change in NX because S-I did not change
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Nominal Exchange and Inflation
EUR PUS

USD PEU
 P 
e

 P *
 P *
e  

 P 
Nominal exchange rate times price ratios equal
real exchange rate.
Nominal exchange rate equals real exchange rate
times price ratios (observe which country’s price
level is in the numerator and which in the denominator).
Percentage change in nominal exchange rate
equals percentage change in the real exchange
rate + percentage change in the abroad price level
– percentage change in the home price level.
Ceteris paribus, if inflation at home is larger than
abroad, then the nominal exchange rate should
depreciate. If abroad inflation is higher than home,
nominal exchange rate should appreciate.
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Law of One Price
Tradable goods should have the same
price because of arbitrage.
 Apply the same principle and you get real
exchange rate of one.
 Not even Big Macs follow the law of one
price.

21
2009
http://www.economist.c
om/markets/indicators/
displaystory.cfm?story_i
d=13055650
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