Chapter 5:
The Open Economy
International Trade
A country’s participation is measured by the value
of its
– export as a percentage of GDP
– Import as a percentage of GDP
Data indicate that while international trade is
important in the U.S., it is even more vital for other
countries such as Canada and France.
International Trade
National Income Accounting
The GDP for an open economy:
Y = C + I + G + NX
Consumption = C
Investment = I
Government purchases = G
Net Exports = NX (Exports less Imports)
National Income Identity
Y = C + I + G + NX
Y – C – G = I + NX
S = I + NX
Where S = Y - C - G is National Savings
Saving Investment Identity
Equilibrium in the product market:
S – I(r) = NX
Net Foreign Investment = Trade Balance
If S>I: foreign capital outflow; hence NX>0: trade surplus
If S<I: foreign capital inflow; hence NX<0: trade deficit
Twin Deficits
The federal budget deficit (G>T), reduces national
savings (S = Y – C – G)
Reduced national savings foreign capital inflow,
hence causing a trade deficit (NX<0)
So, budget deficit causes trade deficit
Saving Investment: Small Open Economy
For a small open economy, r = r*, where
r = domestic real interest rate
r* = world real interest rate
So, S – I(r*) = NX
Determination of Real Interest Rate
r
S
NX>0
r*
If r<r*, then S>I for capital outflow
and a trade surplus.
If r>r*, then S<I for capital inflow
and a trade deficit.
r
Domestic real interest rate
r*
NX<0
I(r*)
I
Fiscal Policy at Home
Real interest rate
S2
r*
S1
An increase in G or a decrease in T
results in a lower S. Now S<I induces
capital outflow and a trade deficit.
NX<0
I(r*)
Investment, Saving
Fiscal Policy Abroad
Real interest rate
S
r2*
NX<0
An increase in G or a decrease in T in
the U.S. results in a higher r* causing
S>I and a trade surplus.
r1*
I(r*)
Investment, Saving
Increase in Investment Demand
Real interest rate
S
An increase in I(r*) results in S<I and a
trade deficit.
r*
NX<0
I2(r*)
I1(r*)
Investment, Saving
Exchange Rate
Nominal exchange rate = e: the relative price of the
currency of two countries; e.g., $1 = 120 yen or 1 yen =
$0.00834
Real exchange rate = ε: nominal exchange rate
adjusted for the foreign price difference
ε = e  (P/P*)
where
P = domestic price level
P* = foreign price level
Real Exchange Rate and Trade Balance
ε
NX<0
The lower the real exchange rate, the less
expensive are domestic goods relative to
foreign goods, thus the greater is the net export.
NX>0
NX(ε)
-
0
+
NX
Determinants of Real Exchange Rate
Equilibrium value of ε is determined by:
Net Foreign Investment = Trade Balance
S – I = NX
Here, the quantity of dollars supplied for net
foreign investment equals the quantity of dollars
demanded for the net export of goods and
services.
Determinants of Real Exchange Rate
ε
S-I
ε
Equilibrium real exchange rate
NX(ε)
I
Fiscal Policy at Home
Real exchange rate
S2 - I
S1 - I
ε2
An increase in G or a decrease in T
reduces S, shifting S-I line to the left.
This shift causes ε to increase, but NX
to decrease.
ε1
NX(ε)
NX2
NX1
Net export
Fiscal Policy Abroad
Real exchange rate
S1 - I
S2 - I
ε1
An increase in G or a decrease in T in
the U.S. results in a higher r* causing I
to decrease. This shift causes ε to decrease,
but NX to increase
ε2
NX(ε)
NX1
NX2
Net export
Increase in Investment Demand
Real exchange rate
S – I2
S – I1
ε2
An increase in I shifts S-I line to the left.
This shift causes ε to increase, but NX
to decrease.
ε1
NX(ε)
NX2
NX1
Net export
Effect of Trade Protectionism
Real exchange rate
S-I
ε2
Protectionism reduces the demand
for imports, increasing net export.
A higher NX line causes ε to increase,
with no net change in net export.
ε1
Here the value of foreign
trade is unchanged because
the rise in the real exchange
rate discourages exports, which
offsets the decline in imports.
NX1 = NX2
NX(ε)2
NX(ε)1
Net export
Determinants of Real Exchange Rate
From ε = e * (P/P*), write e = ε (P*/P)
Take percentage rate:
%Δe = %Δε + %ΔP* - %ΔP
%Δe = %Δε + (* - )
Where ( * - ) is the difference in inflation rates of
the two countries
Inflation and Nominal Exchange Rate
Countries with relatively high inflation tend to have
depreciating currencies.
Countries with relatively low inflation tend to have
appreciating currencies.
Inflation and Nominal Exchange Rate