dr Bartłomiej Rokicki
Chair of Macroeconomics and International Trade Theory
Faculty of Economic Sciences, University of Warsaw
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The small open economy
• The small open economy is an economy that is small enough compared
to the world markets in which it participates. As a result that its policies do
not alter world prices, incomes or interest rates.
• The country is thus a price taker in world markets. The term is normally
applied to a country as a whole, although it is sometimes used in the
context of only a single product.
• The term „price taker” applies both to the goods market and the money
market. Hence, the small open economy takes a world’s interest rate as
given.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Closed versus open economy
• In an open economy, we repeal one of the key assumptions for a
closed economy: the expenditure must not be equal to the value
of production.
• Economy may spend more than it produces, if it borrows from the
non-residents or may spend less than the produce, lending a
surplus abroad.
• In an open economy, spending on final goods and services
produced in the country can be divided into four components: Cd +
Id + Gd + EX (with EX being foreign consumption, investment and
government spending on domestic goods and services).
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Flows of capital and net exports balance
• Basic SNA identity:
S – I = NX(CA)
• The difference between saving and investment can be interpreted
as a net outflow of capital (domestic investments abroad on a net
basis).
• Positive net capital outflow means that a country lends to nonresidents national surplus of savings over investment.
• With NX <0 (trade deficit), country is a net borrower at international
financial market.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Investment, savings and the current account
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The Feldstein-Horioka paradox
• In an open economy with perfect capital mobility between countries,
the relationship between national savings and investment should be
relatively small.
• Feldstein and Horioka studied empirically the above relationship.
The estimated equation:
Yet, the estimated parameter = 0.89 and is not close to zero!
• Further attempts to estimate did not change the results significantly.
• Both savings and investment are procyclical, thus move together
with the economic cycle.
• FH interpret the results as evidence of low mobility capital. It is quite
controversial proposal (hence arose the concept of "FeldsteinHorioka puzzle"), as empirical evidence indicate the exact opposite.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The classical model – basic assumptions
• The main assumptions of the model are exactly the same as in
classical model of a closed economy.
• The only difference is that real interest rate do not necessary
balance national savings and investment – since our country has
an access to international capital markets and we are a small
economy (that means that we cannot influence interest rate of
other countries) our real interest rate equals world’s interest rate.
• Production level is determined at a level given by the technology,
production factors resources and the production function:
Y = AF ( K , L )
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The classical model – basic assumptions (2)
• Consumption depends positively on disposable income:
C = C (Y – T)
• Investment depends, in turn, negatively on the real interest rate r:
I = I(r)
• We also know that Y = C + G + I + NX(CA).
• Solving for NX(CA) we have:
NX ( CA ) = [Y − C − G ] − I ( r *) = S − I ( r *)
where
Y–C–G
are the national savings
and r* is the world’s real interest rate.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Determinants of trade balance
• We have that:
NX ( CA ) = [Y − C − G ] − I ( r *) = S − I ( r *)
• The above equation shows what determines savings and
investment, and thus trade balance in equilibrium.
• Savings depend on fiscal policy – the lower the G or the higher
taxes T ceteris paribus, the higher domestic saving.
• Investment depends on the real interest rate – the higher the
world interest rate r *, the lower investment.
• So the balance of trade in equilibrium is determined by the
difference between saving and investment at the world interest
rate why developing countries often run trade deficit?
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Savings and investment in a small open economy
• The diagram shows the relations between
real interest rate, investment, savings and
current account balance.
• In a closed economy the level of interest rate
would be determined by the intersection of
investment curve and savings curve (rclo).
• In case of small open economy, when
world’s interest rate is higher than for closed
economy (r1*) we will face a current account
surplus. On the other hand, lower interest
rate (r2*) means the existence of current
account deficit.
r
S
NX
r1*
rclo
r2*
NX
I(r)
I, S
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The impact of national fiscal policy on balance of payments
• The amount of national savings depends on national fiscal policy.
Since there is:
S=Y–C–G
• It is clear that an increase in G leads to a decrease in S. The same
impact will have a decrease in taxes that causes an increase of
consumption (consumption depends on disposable income). If interest
rate remains unchanged than the investment remains unchanged. As
a result a decrease in savings has to lead to a decrease in net export,
since:
S – I = NX
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Expantionary national fiscal policy
• In case when we start with balance
trade (NX = 0), expansive fiscal
policy (that leads to an increase in
government spending or in
consumption) will cause the
emergence of current account
deficit and capital account surplus.
• It appears that the theoretical
previsions are valid in the real
economy. Hence, budget deficit is
usually accompanied by current
account deficit.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Twin deficits revisited
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The impact of foreign fiscal policy on balance of payments
• If foreign countries are a small part of the
global economy, their fiscal policy may
be neglected, since it does not affect the
world interest rate.
• Yet, in case of a big country, we suppose
that its policy may influence world’s
interest rate. Hence, an expansionary
fiscal policy will cause a decrease in
world’s savings and an increase in
world’s interest rate. As a result, small
open economy will face capital account
deficit and current account surplus.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The impact of change in investment on balance of payments
• Once national investment demand
increases (e.g. due to some
government incentives), a current
account deficit has to appear.
• Investment will be partly financed
by foreign lending – capital account
has to increase.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The nominal exchange rate
• The nominal exchange rate is a relative price of two different
currencies. Therefore, the exchange rate that we find in an exchange
office is a nominal exchange rate.
• It can be defined as:
e = Pcur/Pcur*
where e is a nominal exchange rate, Pcur i Pcur* are currency prices
• The above implies that the nominal exchange rate is defined as a
price of foreign currency in national currency (e.g. 1.3 $ for 1 euro).
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The real exchange rate
• The balance of payments depends though on real and not nominal
exchange rate.
• Real exchange rate is the ratio of prices of foreign goods expressed in
national currency to the price of domestic goods:
q = eP*/P
• An increase in q means that foreign goods became more expensive or
domestic goods become cheaper.
• Such a change affects the demand for domestic and foreign goods: the
higher the real exchange rate, the higher the demand for domestic goods
and lower demand for foreign goods growth of domestic
competitiveness.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The impact of real exchange rate on net exports
• The real exchange rate influences the competitiveness of goods
produced home and abroad.
• The definition of real exchange rate shows that its decrease will
hamper the competitiveness of national products (because their prices
are rising or foreign goods prices are falling). On the other hand once
real exchange rate increases our competitiveness increases as well.
• In other words, the net exports are a function of the real exchange
rate:
NX = NX(q)
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The determinants of real exchange rate
• Since the real exchange rate
depends on the prices of goods
produced home and abroad it is
related to the current account level.
• In equilibrium current account and
capital account must be balanced
so real exchange rate will be
determined by the two accounts.
• As can be seen aside, the real
exchange rate is determined by
intersection of current account
curve (NX) and capital account
curve (S-I).
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The impact of national fiscal policy on the real exchange rate
• Expansionary fiscal policy leads to
a decrease of national savings. As
a result S – I curve shifts to the left.
• This causes decline in demand for
foreign currencies (declining
domestic investment abroad).
• With foreign currency depreciation
and with real appreciation of
domestic currency, domestic goods
become more expensive and less
competitive.
• So, exports fall and we face current
account deficit.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The impact of foreign fiscal policy on real exchange rate
• Expansionary fiscal policy run by
a big open economy will cause
an increase in world’s interest
rate.
• Hence, national investment will
fall and the curve S – I will shift to
the right.
• As a result both real exchange
rate and net exports will increase.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The impact of change in investment on real exchange rate
• The impact of increase in
investment demand is exactly the
same as an impact of decrease
in national savings (e.g. as e
result of expansionary fiscal
policy).
• This causes decline in demand
for foreign currencies (declining
domestic investment abroad).
• So there will be a fall in both the
real exchange rate and the net
exports.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The impact of protectionist trade policy on the real exchange rate
•
Decline in imports at a current level of real
exchange causes a fall in demand for
foreign currency. Hence, there will be an
appreciation of national currency.
•
National currency real appreciation
makes the domestic exports’
attractiveness decreased.
•
In the new equilibrium the trade balance
remains unchanged. However, since the
volume of trade is reduced, this type of
policy leads to a pure welfare loss, both
for country and for the rest of the world.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Question 1. Show graphically the model of small open economy using
both the graph with interest rate and the level of savings and investment
and the graph with real exchange rate and NX. For what level of interest
rate there will be a current account deficit? For what level of interest rate
there will be a current account surplus?
Question 2. People sometimes talk about “twin deficits" where the twins
are the current account and the government budget deficit. Explain how
these tow deficits are related economically so that changes in one are
reflected in changes in the other.
Question 3. Imagine that the government of a small open economy
receives an important transfer from abroad. How would it influence S, I, q
and CA if the government spent it entirely on public consumption?
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Question 4. Consider a small open economy that initially has its budget
and current account balanced. What would happen with the income,
national savings, investment, trade balance, real interest rate and the
real exchange rate once there is an improvement in production
technology in the home country? Would we face a twin deficits in this
case? Please, answer the question using algebra and drawing the
necessary diagrams.
Question 5. Lets suppose that the government of small open economy
has decided to decrease its spending. At the same time they decided to
lower lump taxes the way that the budget deficit would remain constant.
How would it affect the trade balance, investment and the real interest
rate?
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Question 6. The US recession has forced Barrack Obama administration
to apply fiscal expansion on an unprecedented scale. At the same the
capital is outflowing from the East Europe region, including Poland, due
to fears concerning the possibility of public finance insolvency. Using the
classical model of an open economy, please show how this happenings
will influence the structure of aggregate demand in Poland (e.g. C, I, G,
NX) and the real exchange rate. Let’s suppose that the consumption is
not related to the interest rate and that there is a current account deficit.
Is there any policy that can be applied by Polish government in order to
keep current account balance unchanged?
Question 7. Imagine that the government of a big open economy
increases pensions. How would it influence savings, investment, current
account balance and the real exchange rate of the small open economy?
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Question 8. Production function of a small open economy takes a form of:
Y = AK 1 / 3 L2 / 3
where A=1,25
I=5000-100r
K=L=8000
G=1100
C=100+0,8(Y-T)
NX=500-50q
T=1500
r*=10.
Please, calculate:
•
•
•
•
•
the level of C, I, NX, q in equilibrium;
the change of C, I, NX, q after a decrease of c by 0,2;
the change of C, I, NX, q after an increase of G by 500;
the change of C, I, NX, q after a decrease of r* by 3 percentage points;
the change of C, I, NX, q after an increase of output by 20% (caused by
technological progress);
• the change of C, I, NX, q after a decrease of autonomous investment
by 1000.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Question 9. Imagine that the production function of a small open
economy is given by:
Y = AK 1/ 2 L1/ 2
where A=1,25
I=1000-6000r
K=L=3600
G=1200
C=200+0,75Yd
CA=-600+600q
T=900
r*=5.
Please, calculate:
• The level of C, I, S, FA, CA and q in equilibrium if we are a closed
economy;
• The level of C, I, S, FA, CA and q in equilibrium if we open our
economy;
• Draw the necessary diagrams showing the difference between the
closed and the open economy in this particular case;
• How should change the government spending in order to assure the
CA equilibrium? What would happen to the real exchange rate?