CHAPTER FIVE
The Open Economy
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Chapter Five
Y = C + I + G + NX
Total demand
for domestic
output
is composed
of
Investment
spending by
businesses and
households
Net exports
or net foreign
demand
Consumption
Government
spending by purchases of goods
households
and services
Note: NX = EX-IM.
Domestic spending on all goods and services =domestic spending
on domestics goods and services + on foreign goods and services.
C + G + I = Y - EX + IM
Chapter Five
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1
What do Net Exports cover?
Y+IM= C+G+I+EX
The national income accounts identity can be re-written as:
NX = Y - (C + I + G)
Net Exports
Output
Domestic
Spending
Domestic spending need not equal the output of goods and services.
If output (Y) > domestic spending (C+I+G): we export the difference:
net exports are positive ( NX > 0 ).
If output (Y) < domestic spending (C+I+G): we import the difference:
net exports are negative ( NX < 0 ).
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Chapter Five
Start with the national income accounts identity. Y=C+I+G+NX.
National saving: Y- C - G = I + NX.
S: national saving, S = I + NX.
Relationship of Savings and Investment: S – I = NX.
An economy’s net exports must always equal the difference between
its saving and its investment.
S – I = NX
Trade Balance
Net Foreign Investment
Net foreign investment: the part of national savings
which is not invested at home, that is: net capital outflow
Chapter Five
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2
Net Capital Outflow = Trade Balance
S-I=NX
• 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.
What happens with international flows of capital and goods?
How does the trade balance respond to changes in policy?
Model of a small open economy
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Chapter Five
Real
interest
rate, r*
r*
rclosed
r*'
S
NX
In a closed economy, r adjusts to
equilibrate saving and investment.
• In a small open economy, the
interest rate is set by world
financial markets (r*).
• The difference between saving
and investment determines the
trade balance (NX).
I(r)
NX
Investment, Saving, I, S
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.
Chapter Five
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• Trade balance = net capital outflow = saving - investment
(NX = S - I)
• our model focuses on saving and investment.
• Now the real interest rates are defined in world financial markets,
so they cannot equilibrate national saving and investment.
• Instead: the economy can 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, r = r*.
• In a closed economy: the interest rate is determined by the equilibrium of
domestic saving and investment
• 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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Chapter Five
Y = Y = F(K,L)
C = C (Y-T)
I = I (r)
NX = (Y-C-G) - I
or NX = S - I
The economy’s output Y is fixed by the
factors of production and the production
function.
Consumption is positively related to
disposable income (Y-T).
Investment is negatively related to the
real interest rate.
The national income accounts identity,
expressed in terms of saving and investment.
Now the interest rate equals the world interest rate, r*.
NX = (Y-C(Y-T) - G) - I (r*)
NX = S
- I (r*)
The trade balance is determined by the difference between
saving and investment at the world interest rate.
Chapter Five
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4
An increase in government purchases or a cut in taxes
decreases national saving and thus
shifts the national saving schedule to the left.
Real
S'
S
interest
NX = (Y-C(Y-T) - G) - I (r*)
rate, r*
NX = S
- I (r*)
The result is :
a reduction in national saving
which leads to a trade deficit,
where I > S.
I(r)
r*
NX
Investment, Saving, I, S
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Chapter Five
A fiscal expansion in a foreign economy large enough to influence
world saving and investment raises the world interest rate
from r1* to r2*.
Real
interest
rate, r*
S
The higher world interest rate
reduces investment
in this small open economy,
causing a trade surplus where S > I.
r2*
r1*
NX
I(r)
Investment, Saving, I, S
Chapter Five
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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*.
Real
interest
rate, r*
As a result, investment now
exceeds saving I > S,
which means the economy is
borrowing from abroad and
running a trade deficit.
S
r1*
NX
I(r)2
I(r)1
Investment, Saving, I, S
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Chapter Five
The exchange rate between two countries is the price at which
residents of those countries trade with each other.
• relative price of the currency of two
countries
• denoted as e
• relative price of the goods of two countries,
• sometimes called the terms of trade,
• denoted as ε
Chapter Five
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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.
ε
• The real exchange rate is the rate at which we can trade the goods
of one country for the goods of another.
• Example: An American car costs $10,000 ; a similar Japanese
car costs 2,400,000 yen.
• If 1dollar = 120 yen, then the American car costs 1,200,000 yen.
• The American car costs one-half of what the Japanese car costs.
• We can exchange 2 American cars for 1 Japanese car.
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Chapter Five
ε
The real exchange rate is the rate at which we can trade the goods
of one country for the goods of another :
Real Exchange Rate =
(120 yen/dollar) × (10,000 dollars/American car)
(2,400,000 yen/Japanese Car)
= 0.5 × Japanese Car / American Car
More generally, 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.
ε = e × (P/P*)
• If the real exchange rate is high, foreign goods are
relatively cheap, and domestic goods are expensive.
• If the real exchange rate is low, foreign goods are
relatively expensive, and domestic goods are cheap.
P is the price level of the domestic country (measured in the domestic currency)
P* is the price level of the foreign country (measured in the foreign currency).
Chapter Five
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All changes in a nation’s price level will be fully incorporated into
the nominal exchange rate.
Purchasing Power Parity suggests that
• nominal exchange rate movements primarily reflect differences in
price levels of nations; 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.
• 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 with a very flat
net-exports schedule.
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Chapter Five
S-I
Real
exchange
rate, ε
The real exchange rate is determined by the
intersection of
• the vertical line representing saving minus investment
• and downward-sloping net exports schedule.
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Chapter Five
• 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.
Here the quantity of dollars
NX(ε) supplied for net foreign
investment equals the
Net Exports, NX
quantity of dollars demanded
for the net exports of goods
and services.
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Example (Book, p.143, Problem 2
• Consider an economy described by the following equations:
• Y = C + I + G + NX, Y = 5000, G = 1000, T = 1000,
• C = 250 + 0.75(Y − T), I = 1000 − 50r, NX = 500 − 500ε, r = r* = 5.
a. In this economy, solve for
– national saving,
– investment,
– the trade balance, and
– the equilibrium exchange rate.
b. Suppose now that G rises to 1250.
Solve for national saving, investment, the trade balance, and the
equilibrium exchange rate. Explain what you find.
c. Now suppose that the world interest rate rises from 5 to 10
percent. (G is again 1000).
Solve for national saving, investment, the trade balance, and the
equilibrium exchange rate. Explain what you find.
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Chapter Five
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
Chapter Five
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