6

The Open Economy

MACROECONOMICS
N. Gregory Mankiw
PowerPoint ® Slides by Ron Cronovich
© 2013 Worth Publishers, all rights reserved
 IN THIS CHAPTER, YOU WILL LEARN:

▪ accounting identities for the open economy

▪ the small open economy model
▪ what makes it “small”
▪ how the trade balance and exchange rate are
determined
▪ how policies affect trade balance & exchange
rate

1
 In an open economy,
▪ spending need not equal output
▪ saving need not equal investment

CHAPTER 6 The Open Economy 2

 The national income identity
in an open economy

Y = C + I + G + NX

or, NX = Y – (C + I + G )

domestic
net exports spending

output

CHAPTER 6 The Open Economy 3

 Trade surpluses and deficits

NX = EX – IM = Y – (C + I + G )

▪ trade surplus:
output > spending and exports > imports
Size of the trade surplus = NX
▪ trade deficit:
spending > output and imports > exports
Size of the trade deficit = –NX

CHAPTER 6 The Open Economy 4

 International capital flows
▪ Net capital outflow
=S –I
= net outflow of “loanable funds”
= net purchases of foreign assets
the country’s purchases of foreign assets
minus foreign purchases of domestic assets

▪ When S > I, country is a net lender

▪ When S < I, country is a net borrower

CHAPTER 6 The Open Economy 5

 The link between trade & cap. flows

NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
= S – I
trade balance = net capital outflow

Thus,
a country with a trade deficit (NX < 0)
is a net borrower (S < I ).

CHAPTER 6 The Open Economy 6

 Saving, investment, and the trade balance
1960–2012
25% 15%
investment
Saving, Investment (% of GDP)

Trade Balance (% of GDP)

20% 10%

15% 5%
saving
10% 0%

5% -5%
trade balance
(right scale)
0% -10%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 U.S.: The world’s largest debtor nation
▪ Every year since 1980s: huge trade deficits and
net capital inflows, i.e. net borrowing from abroad
▪ As of 12/31/2011:
▪ U.S. residents owned $21.1 trillion worth of
foreign assets
▪ Foreigners owned $25.1 trillion worth of
U.S. assets
▪ U.S. net indebtedness to rest of the world:
$4.0 trillion—higher than any other country,
hence U.S. is the “world’s largest debtor nation”
CHAPTER 6 The Open Economy 8
 Saving and investment in a
small open economy
▪ An open-economy version of the loanable
funds model from Chapter 3.
▪ Includes many of the same elements:
▪ production function Y = Y = F (K , L )
▪ consumption function C = C (Y − T )
▪ investment function I = I (r )
▪ exogenous policy variables G = G , T = T

CHAPTER 6 The Open Economy 9

 National saving:
The supply of loanable funds
r S = Y − C (Y − T ) − G

As in Chapter 3,
national saving does
not depend on the
interest rate

S S, I
CHAPTER 6 The Open Economy 10
 Assumptions about capital flows

a. domestic & foreign bonds are perfect substitutes

(same risk, maturity, etc.)
b. perfect capital mobility:
no restrictions on international trade in assets
c. economy is small:
cannot affect the world interest rate, denoted r*

a & b imply r = r*
c implies r* is exogenous
CHAPTER 6 The Open Economy 11
 Investment:
The demand for loanable funds
r Investment is still a
downward-sloping function
of the interest rate,
but the exogenous
world interest rate…
r*
…determines the
country’s level of
investment.
I (r )

I (r* ) S, I
CHAPTER 6 The Open Economy 12
 If the economy were closed…
r S
…the interest
rate would
adjust to
equate
investment
and saving: rc
I (r )

I (rc ) S, I
=S
CHAPTER 6 The Open Economy 13
 But in a small open economy…
r
the exogenous S
world interest
rate determines
investment… NX
r*
…and the
difference rc
between saving
and investment I (r )
determines net
capital outflow I1 S, I
and net exports
CHAPTER 6 The Open Economy 14
 Next, three experiments:
1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

(exercise)

CHAPTER 6 The Open Economy 15

 1. Fiscal policy at home
r S 2 S1
An increase in G
or decrease in T NX2
reduces saving. r1
*

NX1
Results:
I = 0
NX = S  0 I (r )

I1 S, I

CHAPTER 6 The Open Economy 16

 NX and the federal budget deficit
(% of GDP), 1965–2012
10% 2%
Budget deficit
8% (left scale)
0%
6%

4%
-2%
2%

0%
-4%
Net exports
-2% (right scale)
-4% -6%
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 2. Fiscal policy abroad
r S1
Expansionary
NX2
fiscal policy
abroad raises r2*
NX1
the world
r1
*
interest rate.

Results:
I  0 I (r )
NX = −I  0 S, I
I (r )
2
*
I (r1* )

CHAPTER 6 The Open Economy 18

NOW YOU TRY
3. An increase in investment demand
r
Use the S
model to
determine r*
the impact of
an increase
NX1
in investment
demand on
NX, S, I, and I (r )1
net capital
outflow. I1 S, I

19
ANSWERS
3. An increase in investment demand
r
S
I > 0, NX2
S = 0, r*
net capital
outflow and
NX fall NX1
by the I (r )2
amount I
I (r )1

I1 I2 S, I

20
 The nominal exchange rate

e = nominal exchange rate,

the relative price of
domestic currency
in terms of foreign currency
(e.g. yen per dollar)

CHAPTER 6 The Open Economy 21

A few exchange rates, as of 5/24/2012

country exchange rate

Euro area 0.79 euro/$
Indonesia 9,437 rupiahs/$
Japan 79.6 yen/$
Mexico 14.0 pesos/$
Russia 31.79 rubles/$
South Africa 8.35 rand/$
U.K. 0.63 pounds/$
 The real exchange rate

ε = real exchange rate,

the relative price of
the lowercase domestic goods
Greek letter in terms of foreign goods
epsilon
(e.g. Japanese Big Macs per
U.S. Big Mac)

CHAPTER 6 The Open Economy 23

 Understanding the units of ε
e P
ε =
P *
(Yen per $)  ($ per unit U.S. goods)
=
Yen per unit Japanese goods

Yen per unit U.S. goods

=
Yen per unit Japanese goods

Units of Japanese goods

=
per unit of U.S. goods

CHAPTER 6 The Open Economy 24

 ~ McZample ~
▪ one good: Big Mac
▪ price in Japan:
P* = 200 Yen
▪ price in USA:
P = $2.50
▪ nominal exchange rate
e = 120 Yen/$ To buy a U.S. Big Mac,
e P someone from Japan
ε = would have to pay an
P*
amount that could buy
120  $2.50
= = 1.5 1.5 Japanese Big Macs.
200 Yen
CHAPTER 6 The Open Economy 25
 ε in the real world & our model
▪ In the real world:
We can think of ε as the relative price of
a basket of domestic goods in terms of a basket
of foreign goods
▪ In our macro model:
There’s just one good, “output.”
So ε is the relative price of one country’s output
in terms of the other country’s output

CHAPTER 6 The Open Economy 26

 How NX depends on ε

ε  U.S. goods become more expensive

relative to foreign goods
 EX, IM
 NX

CHAPTER 6 The Open Economy 27

 U.S. net exports and the real exchange rate,
1973–2012
4% 140
Trade-weighted real
2%
exchange rate index 120

Index (March 1973 = 100)

100
NX (% of GDP)

0%
80
-2%
60
-4%
40

-6% Net exports

20
(left scale)
-8% 0
1970 1975 1980 1985 1990 1995 2000 2005 2010
 The net exports function

▪ The net exports function reflects this inverse

relationship between NX and ε :

NX = NX(ε )

CHAPTER 6 The Open Economy 29

 The NX curve for the U.S.

so U.S. net
When ε is exports will
relatively low, be high
U.S. goods are
relatively ε1
inexpensive
NX (ε)
0
NX(ε1) NX
CHAPTER 6 The Open Economy 30
 The NX curve for the U.S.

ε At high enough
values of ε,
ε2 U.S. goods become
so expensive that
we export
less than
we import

NX (ε)
NX(ε2) 0 NX
CHAPTER 6 The Open Economy 31
 How ε is determined

▪ The accounting identity says NX = S – I

▪ We saw earlier how S – I is determined:
▪ S depends on domestic factors (output, fiscal
policy variables, etc.)
▪ I is determined by the world interest
rate r *
▪ So, ε must adjust to ensure
NX (ε ) = S − I (r *)

CHAPTER 6 The Open Economy 32

 How ε is determined

Neither S nor I
ε S 1 − I (r *)
depends on ε,
so the net capital
outflow curve is
vertical.

ε1
ε adjusts to
equate NX NX(ε )
with net capital
outflow, S − I. NX
NX 1

CHAPTER 6 The Open Economy 33

 Interpretation: supply and demand
in the foreign exchange market
demand: S 1 − I (r *)
ε
Foreigners need
dollars to buy
U.S. net exports.

supply: ε1
Net capital
outflow (S − I ) NX(ε )
is the supply of
NX
dollars to be NX 1
invested abroad.
CHAPTER 6 The Open Economy 34
 Next, four experiments:
1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

(exercise)

4. Trade policy to restrict imports

CHAPTER 6 The Open Economy 35

 1. Fiscal policy at home

A fiscal expansion S 2 − I (r *)
reduces national ε S 1 − I (r *)
saving, net capital
outflow, and the ε2
supply of dollars
in the foreign
exchange ε1
market…
NX(ε )
…causing the real
NX
exchange rate to NX 2 NX 1
rise and NX to fall.
CHAPTER 6 The Open Economy 36
 2. Fiscal policy abroad

An increase in r* S 1 − I (r1 *)
reduces
ε S 1 − I (r2 *)
investment,
increasing net
capital outflow ε1
and the supply of
dollars in the ε2
foreign exchange
market… NX(ε )

…causing the real NX

NX 1 NX 2
exchange rate to fall
and NX to rise.
CHAPTER 6 The Open Economy 37
NOW YOU TRY
3. Increase in investment demand

Determine the ε S1 − I 1
impact of an
increase in
investment
demand on
net exports, ε1
net capital
outflow, NX(ε )
and the real NX
exchange rate. NX 1

38
ANSWERS
3. Increase in investment demand
S1 − I 2
An increase in
ε S1 − I 1
investment
reduces net
capital outflow ε2
and the supply
of dollars in the
foreign ε1
exchange
NX(ε )
market…
NX
…causing the real NX 2 NX 1
exchange rate to
rise and NX to fall.
39
 4. Trade policy to restrict imports
At any given value of
ε, an import quota S −I
ε
 IM  NX
 demand for
dollars shifts
ε2
right
ε1
NX (ε )2
Trade policy doesn’t
affect S or I , so NX (ε )1
capital flows and the
NX
supply of dollars NX1
remain fixed.
CHAPTER 6 The Open Economy 40
 4. Trade policy to restrict imports

Results:
ε S −I
ε > 0
(demand
increase) ε2
NX = 0
(supply fixed) ε1
IM < 0 NX (ε )2
(policy)
NX (ε )1
EX < 0
(rise in ε ) NX
NX1

CHAPTER 6 The Open Economy 41

 The determinants of the
nominal exchange rate
▪ Start with the expression for the real exchange
rate: e P
ε =
P*
▪ Solve for the nominal exchange rate:
P*
e = ε 
P

CHAPTER 6 The Open Economy 42

 The determinants of the
nominal exchange rate
▪ So e depends on the real exchange rate and
the price levels at home and abroad…
…and we know how each
of them is determined: M*
= L *
(r * +  *, Y *
)
P *

P*
e = ε 
P
M
= L (r * +  , Y )
NX (ε ) = S − I (r *) P

CHAPTER 6 The Open Economy 43

 The determinants of the
nominal exchange rate
P*
e = ε 
P
▪ Rewrite this equation in growth rates
(see “arithmetic tricks for working with percentage
changes,” Chapter 2 ):

e ε P * P ε
= + − = + * − 
e ε P* P ε
▪ For a given value of ε,
the growth rate of e equals the difference
between foreign and domestic inflation rates.
CHAPTER 6 The Open Economy 44
 Inflation differentials and nominal exchange
rates for a cross section of countries
% change 8%
in nominal Iceland
6% Pakistan
exchange
rate 4% Mexico

2% U.K. S. Africa
Sweden S. Korea
0%
Japan Denmark
-2%
Canada
Singapore
-4% Australia
Switzerland New Zealand
-6%
-4% -2% 0% 2% 4% 6% 8%
inflation differential
 Purchasing Power Parity (PPP)

Two definitions:
▪ A doctrine that states that goods must sell at the
same (currency-adjusted) price in all countries.
▪ The nominal exchange rate adjusts to equalize
the cost of a basket of goods across countries.
Reasoning:
▪ arbitrage, the law of one price

CHAPTER 6 The Open Economy 46

 Purchasing Power Parity (PPP)

▪ PPP: e P = P* Cost of a basket of

foreign goods, in
foreign currency.

Cost of a basket of Cost of a basket of

domestic goods, in domestic goods, in
foreign currency. domestic currency.

▪ Solve for e : e = P*/ P

▪ PPP implies that the nominal exchange rate
between two countries equals the ratio of the
countries’ price levels.
CHAPTER 6 The Open Economy 47
 Purchasing Power Parity (PPP)

▪ If e = P*/P,
then ε = e 
P P *
P
=  * =1
P *
P P
and the NX curve is horizontal:
ε
S −I Under PPP,
changes in
(S – I ) have no
ε =1 NX impact on ε or e.

NX
CHAPTER 6 The Open Economy 48
 Does PPP hold in the real world?
No, for two reasons:
1. International arbitrage not possible.
▪ nontraded goods
▪ transportation costs
2. Different countries’ goods not perfect substitutes.

Yet, PPP is a useful theory:

▪ It’s simple & intuitive.
▪ In the real world, nominal exchange rates
tend toward their PPP values over the long run.

CHAPTER 6 The Open Economy 49

CASE STUDY:
The Reagan deficits revisited
actual closed small open
1970s 1980s
change economy economy
G–T 2.2 3.9   
S 19.6 17.4   
r 1.1 6.3   no change
I 19.9 19.4   no change
NX -0.3 -2.0  no change 
ε 115.1 129.4  no change 
Data: decade averages; all except r and ε are expressed as a percent of GDP;
ε is a trade-weighted index.
 CHAPTER SUMMARY
▪ Net exports—the difference between
▪ exports and imports
▪ a country’s output (Y )
and its spending (C + I + G)

▪ Net capital outflow equals

▪ purchases of foreign assets
minus foreign purchases of the country’s assets
▪ the difference between saving and investment

51
 CHAPTER SUMMARY
▪ National income accounts identities
▪ Y = C + I + G + NX
▪ trade balance NX = S – I net capital outflow
▪ Impact of policies on NX
▪ NX increases if policy causes S to rise
or I to fall
▪ NX does not change if policy affects
neither S nor I. Example: trade policy

52
 CHAPTER SUMMARY
▪ Exchange rates
▪ nominal: the price of a country’s currency in
terms of another country’s currency
▪ real: the price of a country’s goods in terms of
another country’s goods
▪ The real exchange rate equals the nominal rate
times the ratio of prices of the two countries.

53
 CHAPTER SUMMARY
▪ How the real exchange rate is determined
▪ NX depends negatively on the real exchange
rate, other things equal
▪ The real exchange rate adjusts to equate
NX with net capital outflow

54
 CHAPTER SUMMARY

▪ How the nominal exchange rate is determined

▪ e equals the real exchange rate times the
country’s price level relative to the foreign price
level.
▪ For a given value of the real exchange rate, the
percentage change in the nominal exchange rate
equals the difference between the foreign &
domestic inflation rates.

55