INTERMEDIATE

MACROECONOMICS (ECN 2215)

THE OPEN ECONOMY
BY CHARLES M. BANDA
NOTES EXTRACTED FROM MANKIW
 Y = C + I + G + NX
Investment
Total demand
is composed spending by Net exports
for domestic
of businesses and or net foreign
output
households demand

Consumption Government
spending by purchases of goods
households and services

Notice we’ve added net exports, NX, defined as EX-IM. Also, note that
domestic spending on all goods and services is the sum of domestic
spending on domestics goods and services and on foreign goods and
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services.
 Y = C + I + G + NX
After some manipulation, the national income accounts identity can be
re-written as:
NX = Y - (C + I + G)

Net Exports Domestic

Output Spending

This equation shows that in an open economy, domestic spending need

not equal the output of goods and services. If output exceeds domestic
spending, we export the difference: net exports are positive. If output
falls short of domestic spending, we import the difference: net exports
are negative.
Start with the national income accounts identity. Y=C+I+G+NX.
Subtract C and G from both sides and obtain Y-C-G = I+NX.

Let’s call this S, national saving.

So, now we have S=I+NX. Subtract I from both sides to obtain the new
equation, S-I=NX.
This form of the national income accounts identity shows that an
economy’s net exports must always equal the difference between its
saving and its investment.
S-I=NX

Trade Balance
Net Foreign Investment
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 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.
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We are now going to develop a model of the international
flows of capital and goods. Then, we’ll address issues
such as how the trade balance responds to changes in
policy.

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Recall that the trade balance equals the net capital outflow, which
in turn equals saving minus investment, our model focuses on saving
and investment. We’ll borrow a part of the model from Chapter 3, but
won’t assume that the real interest rate equilibrates saving and
investment. Instead, we’ll allow the economy to 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, denoted r = r*.

Remember in a closed economy, what determines the interest rate is the

equilibrium of domestic saving and investment--and in a way, 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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 Y = Y = F(K,L) The economy’s output Y is fixed by the
factors of production and the production
function.
C = C (Y-T) Consumption is positively related to
disposable income (Y-T).
I = I (r) Investment is negatively related to the
real interest rate.
NX = (Y-C-G) - I The national income accounts identity,
or NX = S - I expressed in terms of saving and investment.
Now substitute our three assumptions from Chapter 3 and the condition
that the interest rate equals the world interest rate, r*.
NX = (Y-C(Y-T) - G) - I (r*)
NX = S - I (r*)
This equation suggests that the trade balance is determined by the
difference between saving and investment at the world interest rate.
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 Real
interest S In a closed economy, r adjusts to
rate, r* equilibrate saving and investment.
NX
In a small open economy, the
r* interest rate is set by world
financial markets. The difference
between saving and investment
rclosed determines the trade balance.
r*' 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. 9
An increase in government purchases or a cut in taxes decreases
national saving and thus shifts the national saving schedule to the left.

Real
interest S' S
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,
r* where I > S.

NX I(r)
Investment, Saving, I, S
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 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 S
rate, r*
The higher world interest rate reduces
investment in this small open
economy, causing a trade surplus
r2*
where S > I.
r1* NX

I(r)
Investment, Saving, I, S
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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*.
As a result, investment now
Real exceeds saving I > S, which
interest S means the economy is
rate, r* borrowing from abroad and
running a trade deficit.

r1*
I(r)2
NX I(r)1
Investment, Saving, I, S
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In the next few slides, we’ll learn about the foreign
exchange market, exchange rates and much more!
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Let’s think about when the US and Japan engage in trade. Each country
has different cultures, languages, and currencies, all of which could
hinder trade. But, because of the foreign exchange market, trade
transactions become more efficient. The foreign exchange market is a
global market in which banks are connected through high-tech
telecommunications systems in order to purchase currencies for their
customers.
The next slide is a graphical representation of the flow of the trade
between the U.S. and Japan, and how the mix of traded things might be
different, but is always balanced. Also, notice how the foreign exchange
market will play the middle-man in these transactions. For instance, the
foreign exchange market converts the supply of dollars from the U.S.
into the demand for yen, and conversely, the supply of yen into the
demand for dollars.
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 In order for the U.S to pay for its imports of
goods and services and securities from Japan,
it must supply dollars which are then converted
into yen by the
foreign
exchange
market.
DemandYEN Supply$
Foreign
Exchange
Market
SupplyYEN Demand$

In order for Japan to pay for its imports of

goods and services and securities from the
U.S., it must supply yen which are then converted
into dollars by the foreign exchange15market.
The exchange rate between two countries is the price at which
residents of those countries trade with each other.

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 -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 e

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The nominal exchange rate is 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.
A Japanese who wants to obtain dollars would pay 120 yen for each
dollar he bought. An American who wants to obtain yen would get
120 yen for each dollar he paid. When people refer to “the exchange
rate” between two countries, they usually mean the nominal exchange
rate.

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Suppose that there is an increase in the demand for U.S. goods and
services. How will this affect the nominal exchange rate?

e S$ D$ shifts rightward and increases

the nominal exchange rate, e.
e1 This is known as appreciation
B
A of the dollar.
e0
Events which decrease the
demand for the dollar, and thus
D  decrease e would be a
$

D$ depreciation of the dollar.

$
Dollar Value of Transactions
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 e
The real exchange rate is the relative price of the goods of two
countries. That is, the real exchange rate tells us the rate at which we
can trade the goods of one country for the goods of another.

To see the difference between the real and nominal exchange rates,
consider a single good produced in many countries: cars. Suppose an
American car costs $10,000 and a similar Japanese car costs 2,400,000
yen. To compare the prices of the two cars, we must convert them into
a common currency. If a dollar is worth 120 yen, then the American
car costs 1,200,000 yen. Comparing the price of the American car
(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), we
conclude that the American car costs one-half of what the Japanese
car costs. In other words, at current prices, we can exchange 2
American cars for 1 Japanese car. 20
 e
We can summarize our calculation as follows:
Real Exchange Rate = (120 yen/dollar)  (10,000 dollars/American car)
(2,400,000 yen/Japanese Car)
= 0.5 Japanese Car
American Car
At these prices, and this exchange rate, we obtain one-half of a Japanese
car per American car. More generally, we can write this calculation as
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.
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 Nominal
Real Exchange Exchange Ratio of Price
Rate Rate Levels

e = e × (P/P*)
Note: P is the price level of the domestic country (measured
in the domestic currency) and P* is the price level of the
foreign country (measured in the foreign currency).

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 Real Exchange Nominal Exchange Ratio of Price
Rate Rate Levels
e = e × (P/P*)

• The real exchange rate between two countries is computed from

the nominal exchange rate and the price levels in the two countries.
• If the real exchange rate is high, foreign goods are relatively cheap,
and domestic goods are relatively expensive.
• If the real exchange rate is low, foreign goods are relatively
expensive, and domestic goods are relatively cheap.

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All changes in a nation’s price level will be fully incorporated into
the nominal exchange rate. It is the law of one price applied to the
international marketplace.

Purchasing Power Parity suggests that nominal exchange rate

movements primarily reflect differences in price levels of nations. It
states that if international arbitrage is possible, then 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.
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Real The law of one price applied to the
exchange S-I international marketplace suggests that
rate, e net exports are highly sensitive to small
movements in the real exchange rate.
This high sensitivity is reflected here
with a very flat net-exports schedule.

NX(e)

Net Exports, NX

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 The relationship between the real exchange rate
and net exports is negative: the lower the real
Real S-I exchange rate, the less expensive are domestic
exchange goods relative to foreign goods, and thus the
rate, e greater are our net exports.
The real exchange rate is determined by the
intersection of the vertical line representing
saving minus investment and downward-sloping
net exports schedule.
Here the quantity of dollars
NX(e) supplied for net foreign
investment equals the
0 Net Exports, NX
quantity of dollars demanded
for the net exports of goods
26 and services.
Real S2-I S1-I Expansionary fiscal policy at home, such as an
exchange increase in government purchases G or a cut in
rate, e taxes, reduces national saving.
The fall in saving reduces the supply of dollars
to be exchanged into foreign currency, from
e2 S1-I to S2-I. This shift raises the equilibrium real
exchange rate from e1 to e2.
e1
NX(e) A reduction in saving reduces

NX2 NX1 Net Exports, NXthe supply of dollars which

causes the real exchange rate
to rise and causes net exports
to fall.
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Real S-I(r1*) S-I (r2*) Expansionary fiscal policy abroad reduces
exchange world saving and raises the world interest
rate, e rate from r1* to r2*.
The increase in the world interest rate reduces
investment at home, which in turn raises the
supply of dollars to be exchanged into foreign
e1
currencies.
e2 As a result, the equilibrium
NX(e) real exchange rate falls from
e1 to e2.
NX1 NX2 Net Exports, NX

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Real S-I2 S-I1 An increase in investment demand raises
exchange the quantity of domestic investment from I1
rate, e to I2.
As a result, the supply of dollars to be
exchanged into foreign currencies falls
from S-I1 to S-I2.
e2
This fall in supply raises the
e1 equilibrium real exchange
NX(e) rate from e1 to e2.

NX2 NX1 Net Exports, NX

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