6

The Open Economy

MACROECONOMICS
N. Gregory Mankiw
Fall 2014
PowerPoint Slides by Ron Cronovich
®
update
© 2015 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

CHAPTER 6 The Open Economy 2

 Imports and exports of selected countries, 2012
Percent of GDP

60

Exports Imports
50

40

30

20

10

0
Australia China Germany Greece S. Korea Mexico United
CHAPTER 6 The Open Economy States 3
 In an open economy,
 Spending need not equal output
Residents of an open economy can spend more than the
country’s output simply by importing foreign goods.
Residents can spend less than output, and the extra output
will be exported.
 Saving need not equal investment
If individuals in an open economy want to save more than
domestic firms want to borrow, no problem. The savers
simply send their extra funds abroad to buy foreign assets.
Similarly, if domestic firms want to borrow more than
individuals are willing to save, then the firms simply borrow
from abroad (i.e. sell bonds to foreigners).

CHAPTER 6 The Open Economy 4

 Preliminaries superscripts:
C C d C f d = spending on
domestic goods
I Id If f = spending on
foreign goods
G G d G f
EX = exports =
foreign spending on domestic goods
IM = imports = C f + I f + G f
= spending on foreign goods
NX = net exports
= EX – IM
CHAPTER 6 The Open Economy 5
 GDP = expenditure on
domestically produced goods & services

Y  C d  I d  G d  EX

 (C  C f )  (I  I f )  (G  G f )  EX

 C  I  G  EX  (C f  I f  G f )

 C  I  G  EX  IM

 C  I  G  NX

CHAPTER 6 The Open Economy 6

 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 7

 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 8

CHAPTER 6 The Open Economy 9
 International capital flows
In a closed economy model of the loanable funds
market. Savers could only lend money to
domestic borrowers. Firms borrowing to finance
their investment could only borrow from domestic
savers. Thus, S = I.
But in an open economy, S need not equal I. A
country’s supply of loanable funds can be used to
finance domestic investment, or to finance foreign
investment (e.g. buying bonds from a foreign
company that needs funding to build a new factory
in its country).
CHAPTER 6 The Open Economy 10
 International capital flows
Net capital outflow: International borrowing and
lending is called “international capital flows” even
though it’s not the physical capital that is flowing
abroad -- we don’t see factories uprooted and
shipped to Mexico. Rather, what can flow
internationally is “loanable funds,” or financial capital,
which of course is used to finance the purchase of
physical capital.
= 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
CHAPTER 6 The Open Economy 11
 International capital flows
The equation “net capital outflow = S – I” shows that if a
country’s savers supply more funds than its firms wish to
borrow for investment, the excess of loanable funds will
flow abroad in the form of net capital outflow (the
purchase of foreign assets). Alternatively, if firms wish to
borrow more than domestic savers wish to lend, then the
firms borrow the excess on international financial markets;
in this case, there’s a net inflow of loanable funds, and S <
I.
When S > I, country is a net lender
When S < I, country is a net borrower

CHAPTER 6 The Open Economy 12

 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 13

 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 3/30/2014:
 U.S. residents owned $23.6 trillion worth of
foreign assets
 Foreigners owned $29.1 trillion worth of
U.S. assets
 U.S. net indebtedness to rest of the world:
$5.5 trillion—higher than any other country,
hence U.S. is the “world’s largest debtor nation”
CHAPTER 6 The Open Economy 14
 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 15

 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 16
 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 17
 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 18
 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 19
 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 20

 A few exchange rates, as of 6/26/2014

country exchange rate

Euro area 0.73 euro/$
Indonesia 12,101 rupiahs/$
Japan 101.7 yen/$
Mexico 13.0 pesos/$
Russia 33.69 rubles/$
South Africa 10.65 rand/$
U.K. 0.59 pounds/$

CHAPTER 6 The Open Economy 21

 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 22

 Understanding the units of ε
e P
ε 
P *
(Yen per $)  ($ per unit U.S. goods)

Yen per unit Japanese goods
the real
exchange rate
Yen per unit U.S. goods measures the
 amount of
Yen per unit Japanese goods
purchasing
power in Japan
Units of Japanese goods that must be
 sacrificed for
per unit of U.S. goods each unit of
purchasing
power in the
CHAPTER 6 The Open Economy U.S. 23
 ~ McZample ~
 one good: Big Mac
 price in Japan:
P* = 200 Yen
 price in USA:
P = $2.50
 nominal exchange rate
e = 120 Yen/$ To
To buy
buy aa U.S.
U.S. Big
Big Mac,
Mac,
e P someone
someone fromfrom Japan
Japan
ε  would
would have
have to to pay
pay an
an
P*
120  $2.50 amount
amount that
that could
could buy
buy
  1.5 1.5
200 Yen 1.5 Japanese
Japanese Big Big Macs.
Macs.
CHAPTER 6 The Open Economy 24
 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 25

 How NX depends on ε

If ε rises:
 U.S. goods become more expensive
relative to foreign goods
 exports fall, imports rise
 net exports fall

CHAPTER 6 The Open Economy 26

 The net export function

 The net export’s function reflects this inverse

relationship between NX and ε :

NX = NX(ε )

CHAPTER 6 The Open Economy 27

 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 28
 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 29
 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 30

 How ε is determined

Neither S nor I S 1  I (r *)
depends on ε, 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 31

 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 32
 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: is the simultaneous purchase and sale of
the same asset in different markets in order to profit
from tiny differences in the asset's listed price.
 The law of one price: Two goods, if they are
identical, must sell for the same price.

CHAPTER 6 The Open Economy 33

 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 34
 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 35

 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

CHAPTER 6 The Open Economy 36

 CHAPTER SUMMARY

 National income accounts identities

 Y = C + I + G + NX
 trade balance NX = S – I net capital outflow

CHAPTER 6 The Open Economy 37

 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

CHAPTER 1 The Science of Macroeconomics 38

 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

CHAPTER 1 The Science of Macroeconomics 39

 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.

CHAPTER 1 The Science of Macroeconomics 40