Open Economy

Macroeconomics
Term 2
Instructor: Dr. Ayona Bhattacharjee
 Introduction

• What is an Open Economy?

• Why should countries trade?
• What are Exports?
• What are Imports?
• What are Net Exports?
• What is Trade Balance?
• What is Trade Deficit?
• What is Trade Surplus?

2
 Introduction

• Closed economies are ones which do not/cannot trade with

other economies
• Four kinds of flows in an open economy – goods, services,
capital and labour
• New areas of trade will open particularly with focus on
green energy
• More services trade likely as technology opens up newer
opportunities
 Global merchandise trade had been on a downward trajectory since GFC

Global merchandise trade

23 22 23 30
22
20
21
20 10
20 19
19 19 0
18
18
-10
17 -11
17 -20
16 -22
15 -30

Global merchandise trade as % of GDP Merchandise trade % y/y (RHS)

Source: Bloomberg
 India benefitted from large services boom

India share in world services exports

6% 5%
5% 5%
5% 5% 4% 4% 5% 5%
4% 4%
4% 4% 4%
3% 3%
3% 3%
2%
2% 2%
1% 1% 2%
1%

0%

Source: Bloomberg
 The U.S. Trade Deficit

During the 1980’s, 1990’s, and 2000’s, the U.S. ran large trade
deficits, with the exact size fluctuating over time. In 2007, the trade
deficit was $708 billion or 5.1% of GDP. During this period the
U.S. went from being the world’s largest creditor to the largest
debtor.

What caused the U.S. trade deficit? There is no single

explanation. But to understand some of the forces at work, look at
national saving and domestic investment

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 The U.S. Trade Deficit
The start of the trade deficit coincided with a fall in national
saving.
This development can be explained by the expansionary fiscal policy
in the 1980’s. With the support of President Reagan, the U.S.
Congress passed legislation in 1981 that substantially cut personal
income taxes over the next three years. Because these tax cuts were
not met with equal cuts in government spending, the federal budget
went into deficit. These budget deficits were the largest ever
experienced in a period of peace and prosperity, and they continued
long after Reagan left office. Such a policy would reduce national
saving, causing a trade deficit. Because the government budget and
the trade balance went into deficit at the same time, these shortfalls
were called the TWIN DEFICITS
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 U.S. Trade Deficit
Things started to change in the 1990s, when the U.S. federal government got its fiscal
house in order. President Bush and President Clinton both signed tax increases, while
Congress put a lid on spending. In addition to these policy changes, rapid productivity
growth in the late 1990s raising incomes and thus further increased tax revenue. These
developments moved the U.S. federal budget to surplus, which in turn caused national
savings to rise.
The increase in national saving did not coincide with a shrinking trade deficit,
because domestic investment rose at the same time. The likely explanation is that the
boom in information technology caused an expansionary shift in the U.S.
investment function. Even though fiscal policy was pushing the trade deficit toward
surplus, the investment boom was an even stronger force pushing the trade balance
toward deficit.
In the early 2000’s, fiscal policy once again put downward pressure on national
saving. President Bush tax cuts were signed into in 2001 and 2003, while the war
on terror led to substantial increases in government spending. The federal
government was again running budget deficits. National saving fell into historic lows,
and the trade deficit reached historic highs.
A few years later, the trade deficit started to shrink, as the economy experienced a
substantial decline in housing prices. Lower house prices reduced housing
investment. They also made households poorer, inducing them to reduce consumption
and increase saving. The trade deficit fell from .1% of GDP as its peak in the fourth
quarter of 2005 to 4.9% in the third quarter of 2007. 8
 Think!

• As U.S. trade deficit started to increase rapidly in the early

to mid 1980s, what should have happened to the U.S.
dollar in that time period?
 Think!

• In the first half of the 1980s the value of the U.S. dollar increased
substantially
• Large inflow of foreign funds that the U.S. experienced in the early
1980s, as a result of high U.S. interest rates. The high interest rates
were caused by the policy mix of fiscal expansion and monetary
restriction in the early Reagan years. This policy combination led to an
increase in the demand for U.S. dollars and a subsequent sharp
increase in the dollar’s value. The currency appreciation made
domestic products less competitive on world markets, causing an
increase in the U.S. trade deficit. In other words we had a situation in
which a high currency value caused an increase in the trade deficit
rather than a situation in which a trade deficit cause a decrease in the
currency value
 Exchange Rate
• The level of fluctuations in exchange rates have important implications
for firm performance
• An exchange rate is the price of a currency in terms of another
currency
• Exchange rates are often but not always quoted as a ratio of local
currency and US$
• Exchange rates between any two currencies can be calculated if their
exchange rates in a common currency are known
• Exchange rates are usually quoted as a ratio greater than one –
currencies with less purchasing power than 1USD are quoted as
currency per $

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 Exchange Rate
• The nominal exchange rate is the rate at which a person can trade the
currency of one country for the currency of another
• In units of foreign currency per one unit of domestic currency
• In units of domestic currency per one unit of the foreign currency

• The real exchange rate is the rate at which a person can trade the
goods and services of one country for the goods and services of
another
• Compares the prices of domestic goods and foreign goods in the
domestic economy
• An inflation-adjusted measure of a currency’s purchasing power
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 Nominal Exchange Rate
• Appreciation is an increase in the value of a currency as
measured by the amount of foreign currency units or goods it
can buy
• Currency Strengthened
• If a rupee buys more foreign currency, there is an appreciation of the
rupee
• Example: Exchange rate rises from 1.45 to 1.60 USD per pound. It
takes more USD to buy a pound. This makes US produced goods &
services appear less expensive to potential buyers holding pounds. A
British firm with 1 million pounds could purchase USD1.45 million
worth of goods; can now buy more US goods

13
 Note!

• 𝑀𝑆 rises -> Price level rises -> currency loses value ->
depreciation

• Example: If inflation in the US is 5%, inflation rate in

Germany is 3% and inflation rate in Italy is 9% -> value of
$ falls relative to German mark & value of $ rises relative
to Italian Lira

14
 Nominal Exchange Rate
• Depreciation is a decrease in the value of a currency as
measured by the amount of foreign currency units or goods and
services it can buy
• Currency weakened
• If a rupee buys less foreign currency, there is a depreciation of the
rupee
• Example: If the exchange rate changes from 1.45 USD per pound to
1.33 USD per pound, pound would have lost purchasing power
relative to USD and USD denominated goods and services will
become more expensive to people holding pounds

15
 Real Exchange Rate

• The real exchange rate depends on the nominal exchange

rate and the prices of goods in the two countries measured
in local currencies
(𝑒 𝑃)
𝑅𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 =
𝑃∗
• RER tells us how much a domestic item is worth compared
to a similar foreign item (RER>1, domestic item is more
expensive; RER<1, domestic item is less expensive)

16
 Example

• 1 kg American rice sells for $100

• 1 kg Japanese rice sells for 16000 yen
• What is the real exchange rate between American and
Japanese rice?
• Nominal exchange rate= 80 yen/$

17
 Example

• 1 kg American rice sells for $100

• 1 kg Japanese rice sells for 16000 yen
• What is the real exchange rate between American and Japanese
rice?

Real exchange rate

80 yen per $∗($100 per kg of American rice)
=
16000 yen per kg of Japanese rice

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 Purchasing power parity

• According to the law of one price, a good must sell for the same price
in all locations
• A unit of a currency must have the same real value in all countries
But ….
• Many goods are not easily traded or shipped from one country to
another
• Tradable goods are not perfect substitutes when produced in different
countries

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 Purchasing power parity

• Let the Big Mac be sold for 40 kroner in Norway and

$3.57 in the US => the implied exchange rate should be
11.2 kroner per $
• The actual exchange rate is 6.5 kroner per dollar. So, the
kroner actually was more expensive than the implied
purchasing power parity (PPP)
• Comparison shows that the kroner was over-valued by
72%
 Purchasing power parity
• Let the big mac be sold for $3.57 in the US, $3.69 in Britain,
$4.02 in Brazil, $5.98 in Switzerland, $6.15 in Norway; $3.46 in
Japan, $2.59 in South Korea, $2.39 in Mexico and $1.83 in
China
• Norway had the most expensive big mac; China had the least
expensive big mac
• If we divide the local price in dollar by the US price and
subtract 1 from the quotient, we find the extent of over or under
valuation of local currencies
• Kroner was over-valued by 72%; Yuan was under-valued by
49%
 Mundell-Fleming Model
The economy being studied is a small open economy and there
is perfect capital mobility, meaning that it can borrow or lend
as much as it wants in world financial markets, and therefore, the
economy’s interest rate is controlled by the world interest rate,
mathematically denoted as r = r*.

One key lesson about this model is that the behavior of an

economy
depends on the exchange rate regime it adopts—floating or
fixed.
 Mundell-Fleming Model

• Small open economy

• Perfect capital mobility
• The relationship between the nominal exchange rate and an
economy's output

• 𝑁𝑋 = 𝑁𝑋 (𝑒 ); 𝑁𝑋´(𝑒 ) < 0

23
 Model

• Exogenous variables: 𝐺, 𝑇, 𝑀, 𝑃 and 𝑟 ∗

• Endogenous variables: 𝑒 and 𝑌
• GM eqm:
𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑟 ∗ + 𝐺 + 𝑁𝑋 𝜖
• MM eqm:
𝑀𝑠
= 𝐿(𝑟 ∗ , 𝑌)
𝑃
 The Small Open Economy Under Floating Exchange Rates
IS*: Y = C(Y-T) + I(r*) + G + NX(e)
LM*: M/P = L (r*,Y)

Assumption 1: The domestic interest rate is equal to the world

interest rate (r = r*).
Assumption 2: The price level is exogenously fixed since the
model is used to analyze the short run. This implies that the
nominal exchange rate is proportional to the real exchange rate.
Assumption 3: The money supply is set exogenously by the
central bank.
Assumption 4: LM* curve will be vertical because the exchange
rate does not enter into our LM* equation.
 IS Curve
The IS* curve slopes downward because a higher exchange rate
reduces net exports (since a currency appreciation makes
domestic goods more expensive to foreigners), which in turn,
lowers aggregate income.

Exchange rate, e

IS*
Income, output, Y
 LM Curve

Interest rate, r
LM
The LM curve and
the world interest r = r*
rate together determine
the level of income.
The LM* curve is
Income, output, Y
vertical because the
exchange rate does
LM*
Exchange rate, e
not enter into the LM*
equation.
Recall the LM* equation is:
M/P = L (r*,Y)

Income, output, Y
 MF Model under Floating ‘e’

e LM* LM*'
e LM*
+DG, or –DT  +DM 
+De, no DY -De, +DY

IS*
IS* IS*'
Income, output, Y Income, output, Y
Increase in money supply -> downward
Income rises due to
pressure on the domestic interest rate -> capital flows out
the fiscal expansion-> interest rate rises ->
as investors seek a higher return elsewhere -> capital
capital inflows from abroad -> increase in
outflow prevents the interest rate from falling -> The
the demand for the currency ->
outflow also causes the exchange rate to depreciate ->
domestic goods more expensive
domestic goods less expensive relative to
to foreigners.
foreign goods -> stimulates NX
 Fixed Exchange Rates
Under a fixed exchange rate, the central bank announces a
value for the exchange rate and stands ready to buy and sell
the domestic currency at a predetermined price to keep the
exchange rate at its announced level.

Fixed exchange rates require a commitment of a central bank

to allow the money supply to adjust to whatever level will
ensure that the equilibrium exchange rate in the market for
foreign-currency exchange
 MF Model under Fixed Exchange Rates

+DG, or –DT + DY +DM  no DY

e LM*
e LM* LM*'

IS*
IS* IS*'
Income, output, Y Income, output, Y
A fiscal expansion shifts IS* to the right. To maintain If the Fed tried to increase the money supply by
the fixed exchange rate, the Fed must increase the buying bonds from the public, that would put down-
money supply, thus increasing LM* to the right. ward pressure on the interest rate. Arbitragers respond
Unlike the case with flexible exchange rates, there is no by selling the domestic currency to the central bank,
crowding out effect on NX due to a higher exchange causing the money supply and the LM curve
rate. to contract to their initial positions.
 Summary of policy effects

Exchange rate regimes

Floating Fixed
impact on:

Policy Y e NX Y e NX

fiscal expansion 0    0 0

mon. expansion    0 0 0

slide 31
Foreign-Currency Exchange Market

• The demand curve for foreign currency is downward

sloping because a higher exchange rate makes domestic
goods more expensive

• The supply curve is vertical because the quantity of dollars

supplied for net capital outflow is unrelated to the real
exchange rate.
 Equilibrium in the Open economy

• In the market for loanable funds, supply comes from

national saving and demand comes from domestic
investment and net capital outflow

• In the market for foreign-currency exchange, supply comes

from net capital outflow and demand comes from net
exports.
 Flow of Capital
• NCO is the purchase of foreign assets by domestic residents less the
purchase of domestic assets by foreigners
• What affects NCO?
• The real interest rates on foreign assets v/s real interest rates on
domestic assets
• The perceived economic and political risks of holding assets abroad
• The government policies that affect foreign ownership of domestic
assets

• S = I + NX = I + NCO

34
The Equilibrium in an Open Economy

(a) The Market for Loanable Funds (b) Net Capital Outflow

Real Real
Interest Supply Interest
Rate Rate

r r

Demand Net capital

outflow,
NCO
Quantity of Net Capital
Loanable Funds Outflow

Real
Exchange Supply
Rate

Demand

Quantity of
INR
35
(c) The Market for Foreign-Currency Exchange

Copyright©2003 Southwestern/Thomson Learning

 Policy Effects

• The magnitude and variation in important macroeconomic

variables depend on the following:

• Government budget deficits

• Trade policies
• Political and economic stability
 The Effects of Government Budget Deficit
1. A budget deficit reduces
the supply of loanable funds . . .
(a) The Market for Loanable Funds (b) Net Capital Outflow

Real Real
Interest S S Interest
Rate Rate

B
r2 r2

A
r r
3. . . . which in
2. . . . which
turn reduces
increases
net capital
the real Demand
outflow.
interest NCO
rate . . .
Quantity of Net Capital
Loanable Funds Outflow

Real
Exchange S S
Rate 4. The decrease
in net capital
outflow reduces
the supply of dom currency
to be exchanged
E2
into foreign
currency . . .
5. . . . which E1
causes the
real exchange
rate to Demand
appreciate.

Quantity of dom curr

37

(c) The Market for Foreign-Currency Exchange

 The Effects of an Import Quota
(a) The Market for Loanable Funds (b) Net Capital Outflow

Real Real
Interest Supply Interest
Rate Rate

r r
3. Net exports,
however, remain
the same.
Demand
NCO
Quantity of Net Capital
Loanable Funds Outflow

Real
Exchange Supply
Rate
1. An import
quota increases
the demand for
E2 Dom curr. . .
2. . . . and
causes the E
real exchange
rate to D
appreciate.
D

Quantity of
38
Dom curr

(c) The Market for Foreign-Currency Exchange

 The Effects of Capital Flight

(a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow

Real Real
Interest Supply Interest 1. An increase
Rate Rate in net capital
outflow. . .

r2 r2

r1 r1

3. . . . which D2
increases
the interest
D1
rate. NCO1 NCO2
Quantity of
2. . . . increases the demand Net Capital
for loanable funds . . . Loanable Funds Outflow

Real
Exchange S S2
Rate 4. At the same
time, the increase
in net capital
outflow
E increases the
supply of dom curr. . .
5. . . . which
E
causes the
Dom curr to
depreciate. Demand

Quantity of
Dom curr
39
(c) The Market for Foreign-Currency Exchange
 Balance of Payments (BoP)

• The balance of payments (BoP) is the record of transactions between

a country and the rest of the world that records all international
transactions in goods, services, and assets over a year
• It is the difference of receipts of a country from foreigners and
payments by residents to foreigners
BoP = Receipts of residents of a country from foreigners less the
Payments by residents to foreigners
• Transactions which increase the supply of foreign exchange are
recorded as credits
• Transactions which use foreign exchange are recorded as debits
 Balance of Payments (BoP)

• Individuals and firms have to pay for what they buy abroad
• If a person spends more than her income, her deficit needs to be financed
by selling assets or by borrowing
• Similarly, if a country runs a deficit in its current account the deficit
needs to be financed by selling assets or by borrowing abroad
• Selling/borrowing implies the country is running a capital account surplus 
any current account deficit is of necessity financed by an offsetting capital
inflow
 Balance of Payments

• Overall balance = CA + KA
CA + KA + Monetary movements =0
• OB>0
• Excess of inflows over outflows
• Exchange rate appreciates -> exports fall, imports rise
• OB<0
• Excess of outflows over inflows
• Exchange rate depreciates -> exports rise, imports fall
• Persistent CA deficit must be met through either KA surplus or Reduction
in forex reserves
 Current Account
• Consists of trade and invisibles account
• CA position = trade balance + invisibles balance
• Trade account –
• Shows the credits and debits for merchandise trade
• Trade account surplus (deficit): Exports > (<) Imports
• Invisibles account
• Receipts and payments for non-factor and factor services, transfers
and remittances
• Invisibles balance surplus: Receipts > Debits
 Capital Account
• Captures the net flow of K between a country and ROW
• K flows arise from foreign investment, loans, banking K etc.
• Foreign investments
• FDI: Movement of K which relates to purchase of physical assets.
Long term in nature.
• FII: Movement of K relates to purchase of financial assets. Short term
in nature
• Capital inflow (outflow): Credit (debit) items
• KA balance = Credit – Debit
 Stability Indicators
• CA balance to GDP ratio
• Import coverage of forex reserves
• External debt to GDP ratio
• Short term external debt to GDP
• Short term external debt to forex reserves
• Short term external debt to total external debt
Thank You!