THE SMALL OPEN ECONOMY

BY-
ARUSHI KHANDELWAL-1272
VRINDA MODA-1366
ANSHA BANSAL-1386
KUSH GUPTA-2253
THE QUESTION
NET FOREIGN INVESTMENTS ARE ALWAYS
EQUAL TO THE TRADE BALANCE IN A
SMALL OPEN ECONOMY. COMMENT.
WHAT IS SMALL OPEN ECONOMY?

A small open economy is that economy

which exports and imports goods and
services in the worlds market and forms
a very small part of the world market.
WHAT IS NET EXPORT?
Net export is the difference between exports
and imports of a country. It is the difference
between what our country produces for the
outside market and what it demands from the
same.
An open economys output expenditure can
be divided into two parts:
Domestic spending on domestic goods and
services.
Foreign spending on domestic goods and
services.
DOMESTIC SPENDING
It includes:
Consumption (Cd)
Investment(Id)
Government purchases(Gd)
Domestic Spending = Cd + Id + Gd

FOREIGN SPENDING
It occurs when there are exports of domestic
goods and services. It is given a symbol X.
TOTAL SPENDING (EXPENDITURE)
Total spending(Y) = Cd + Id + Gd + X

C = Cd + Cf or Cd = C Cf

Where, Cd = Consumption of domestic goods and

services

Cf = Consumption of foreign goods and services

C = Total consumption

I = Id + If or Id = I If
 So equation becomes:

Y = (C Cf) + (I If) + (G Gf) + X

Or

Y = C + I + G + X (Cf + If + Gf)
Or

Y=C+I+G+XM

Where, M = imports which is (Cf + If + Gf)

Or
 WHAT IS TRADE BALANCE?
Trade balance is nothing but net exports. Trade balance is nothing
but the amount received for our net exports of goods and services.
Y = C + I + G + NX
Y C G = I + NX
S = I + NX
Where, S = national saving

Why is S = Y C G?
S = Private saving + Public saving
ie. (Y T C) + (T G)
OR Y C G
Hence, S = Y C G

We conclude,
NX = S - I
WHAT IS NET FOREIGN INVESTMENT?

Net Foreign Investment(NFI) is the amount

obtained by subtracting the amount that
foreigners are lending to us from the amount
domestic residents are lending abroad.
It shows the international flow of funds. It is also
called Net Capital Outflow(NCO).
NCO or NFI is the excess of domestic saving over
domestic investment, ie. S I.
When trade balance is Net exports and NCO is
the net flow of funds, then in a small open
economy NX = S I.
 There can be three situations:

1. TRADE SURPLUS: it occurs when savings are more than

investments, ie. When S I is positive. It implies that:
a) We are net lenders to financial market of the world.
b) Our exports are more than our imports so NX would be positive.
2. TRADE DEFICIT: it occurs when savings are less than
investment, ie. S I is negative. It implies that:
a) We are net borrowers from financial markets of the world.
b) Our exports are less than our imports.
3. BALANCED TRADE: it occurs when savings are equal to the
investments, ie. S I is zero. It implies that:
a) Our borrowings are equal to our lendings in the financial
markets of the world.
b) Our exports are equal to our imports.
WHAT HAPPENS IN SMALL OPEN
ECONOMY?

In small open economy it is assumed

that there is perfect capital mobility
which means that the residents of the
country can fully lend or borrow from
world financial markets.
It means:
Real rate in small economy = World
interest rate
Or, r = r*
 ASSUMPTIONS

1. Y = Y, it means that the small open

economy output is fixed by the factors of
productionand production function.
2. C = (Y T)C, which means that
consumption is directly related to
disposable income (Y T)
3. I = I(r), it means investment is inversely
related to real interest rate.
Thus, net exports (NX) = S I
NX = [Y C(Y T) G] I(r*)
Trade Balance = S I(r*)
 RESULT:

1. Trade balance is determined by the

difference between savings and
investment at world interest rate.
2. Savings depend on consumption and
fiscal policy.
3. Investment depends upon investment
function and world interest rate.
 Real S
interest
rate (r) &
(r*)

Trade surplus
S>I

r*1
S=I Balance
r* trade
r*2 I(r*)
Trade deficit
S<I
I,
In the figure, S
S = Savings curve which is vertical line as it does not depend on
the interest rate. It shows supply of loanable funds.
I(r) = It is the investment curve which is downward sloping
because at a higher interest rate, fewer investments are made.
R*1 = Savings are more than Investment, ie. S > I so trade
surplus is there.
R*2 = Savings are less than Investment, ie. S < I so trade deficit
is there.
EFFECTS OF POLICIES ON
TRADE BALANCE IN A
SMALL OPEN ECONOMY
CASE 1: EFFECT OF EXPANSIONARY FISCAL
POLICY AT HOME

If the home country follows an

expansionary policy then government
purchases(G) will increase, or
consumption (C) will increase or taxes(T)
will reduce. As a result, national saving
(S) will reduce because S=Y-C-G. since
the worlds interest rate remains the
same, investment does not change.
 Real
intere S1 S2
st
rate
(r)

A
I>S E
Trade I(r)
defici
0 t Investment
& saving

the figure,
oint E= It is the initial point of balance trade where S=I.
1= It is the new saving curve. Reduction in national saving is shown by leftward
hift of S1 curve.
*= At this unchanged world interest rate, investment exceeds saving.
ade deficit occurs to the extent of AE.
CASE 2: EFFECT OF EXPANSIONARY FISCAL
POLICY ABROAD

If the foreign countries follow an

expansionary fiscal policy in terms of
expansion in government purchases,
then world savings will reduce and
subsequently world interest rate will rise.
It will in turn raise the cost of borrowing
and thus, investment in our small open
economy will fall.
 S
Real
interes
t
rate(r)
Trade
surplus

S>I A1
R2* A
R1*
I(r)

Investment &
saving

In the figure,
R1*= It is the initial world interest rate where S=I and balance trade
occurs.
R2*= Due to fiscal expansion abroad there is fall in world saving. The
world interest rate rises to r2*. There is no change in the domestic
saving S and I curves. At r2* interest rate, saving exceeds
investment. There is a trade surplus equal to AA1.
CASE 3: EFFECT OF SHIFT IN INVESTMENT
DEMAND CURVE

If the government formulates such

policies that increases the investment
then investment schedule will shift
rightward and consequently trade deficit
will take place. The reverse situation will
also hold.
Real S
interes
t rate
(r)

Trade
deficit(I>S
) A1
R* A I(r)
I(r) 1

0 Investment
and saving

In the figure,
R*= Initial world interest rate where S=I(r).
I(r)1= This is the new increased investment schedule in a
small open economy. At this existing world interest rate r*,
investment exceeds saving. There is a trade deficit equal to
AA1.