1. Chapter 5
The Open Economy
(Continued)
CHAPTER 5 The Open Economy

2. Small Open Economy Model
A small economy: The country is small in the sense that it takes the world interest rate (r*) as given.
We relax the assumption that domestic real interest rate is determined when S = I
In fact S >< I
How is the world real interest rate determined? Sworld = Iworld
CHAPTER 5 The Open Economy

3. When r*>rc S>I: Net Capital outflow, KA deficit, CA surplus (=Trade surplus)
CHAPTER 5 The Open Economy

4. When rc >r*,I>S, Net capital inflow, KA surplus, CA deficit (=trade deficit)
S, I
I (r ) rc r*
Trade deficit
CHAPTER 5 The Open Economy

5. Three experiments: 1. Fiscal policy at home 2. Fiscal policy abroad
3. An increase in investment demand
In the textbook, NX = 0 in the economy’s initial equilibrium for each of these three experiments.
In these slides, NX > 0 in the initial equilibrium.
For completeness, you might have your students repeat the three experiments for the case of NX < 0 in the initial equilibrium. This would be a good homework or in-class exercise.
CHAPTER 5 The Open Economy

6. 1. Fiscal Policy at Home
Last time we considered this experiment for r*>rc as the starting point
Try the same experiment for:
r*=rc
r*<rc
For all the alternative starting points, you should reach the same conclusion:
Expansionary fiscal policy reduces NX.
Starting from a balanced trade, it becomes negative
Starting from a trade deficit, the deficit widens
Contractionary fiscal policy increases NX
CHAPTER 5 The Open Economy

7. Suppose there is expansionary FP by a large country  ↓ world savings
2. Fiscal policy abroad
Suppose there is expansionary FP by a large country  ↓ world savings
What happens to world interest rate?
Think of the world as a closed economy
CHAPTER 5 The Open Economy

8. World Interest Rate r S, I r2* r1 I (r ) I 1 S
CHAPTER 5 The Open Economy

9. What happens at home? r S, I I (r )
Expansionary fiscal policy abroad raises the world interest rate.
NX2
NX1
Results:
It might be worth taking a moment to explain that the world interest rate r* is determined by saving and investment in the world loanable funds market. S* is the sum of all countries’ saving; I* the sum of all countries’ investment. r* adjusts to equate I* with S*, just like in Chapter 3, because the world as a whole is a closed economy. A fiscal expansion in other countries would reduce S* and raise r* (same results as in chapter 3).
The higher world interest rate reduces investment in our small open economy, and hence reduces the demand for loanable funds. The supply of loanable funds (national saving) is unchanged, so there’s an increase in the amount of funds flowing abroad.
CHAPTER 5 The Open Economy

10. Try this experiment for the following starting points:
r*=rc
r*<rc
CHAPTER 5 The Open Economy

11. 3. An increase in investment demand
S, I S
I (r )1
I 1
NX1
EXERCISE:
Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.
Have students get out a piece of paper, draw this graph on it, and then do the analysis. A couple minutes should suffice.
It might be useful to have them compare their answers with the results from the closed economy case.
CHAPTER 5 The Open Economy

12. 3. An increase in investment demand
S, I S
I (r )2
I (r )1
NX2
ANSWERS:
ΔI > 0,
ΔS = 0,
net capital outflow and NX fall by the amount ΔI
I 1
NX1
I 2
In contrast to a closed economy, investment is not constrained by the fixed (domestic) supply of loanable funds. Hence, the increase in firm’s demand for loanable funds can be satisfied by borrowing abroad, which reduces net outflow of financial capital. And since net capital outflow = NX, we see a fall in NX equal to the increase in investment.
CHAPTER 5 The Open Economy

13. As I ↑ for a given S, S – I declines
the increase in I is financed by lending less to foreigners
Net capital outflow shrinks (Capital account deficit gets smaller)
Trade surplus shrinks
Or, if you had started with a trade deficit (i.e. r*<rc), the deficit worsens
CHAPTER 5 The Open Economy

14. Evaluating Economic Policy
What would a large trade deficit in a country suggest?
Is it due to low S (bad) or high I (good).
What can a government do to ↓ trade deficit?
Contractionary FP.
Why is this difficult?
CHAPTER 5 The Open Economy

15. The nominal exchange rate
e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency
(e.g. Dollar per Lira)
Warning to students:
Some textbooks and newspapers define the exchange rate as the reciprocal of the one here (e.g., dollars per yen instead of yen per dollar). The one here is easier to use, because a rise in “e” corresponds to an “appreciation” of the country’s currency. Using the reciprocal would mean that a rise in “e” is a depreciation, which seems counter-intuitive.
So it would be worthwhile to point out to students that a country’s “e” is simply the price (measured in foreign currency) of a unit of that country’s currency.
CHAPTER 5 The Open Economy

16. Example The exchange rate between USD and TL is:
A Turk needs to pay 1.40 TL for each USD he/she buys.
An American needs to pay e=1/1.40=$ 0.70 per 1 YL
In this example, the nominal exchange rate is e=0.70 (value of TL in $)
CHAPTER 5 The Open Economy

17. Turkey: Nominal Exchange Rate (1 Dolar + 1 Euro) vs 1 TL

18. the lowercase Greek letter epsilon
The real exchange rate
= real exchange rate, the relative price of the goods of two countries (i.e. rate at which we can trade the goods of one country with the goods of another). Also called terms of trade.
(e.g. US Big Macs per Turkish Big Mac) ε
the lowercase Greek letter epsilon
CHAPTER 5 The Open Economy

19. Example
Price of a suit in Turkey/Price of a suit in US = Real exchange rate
Suppose a suit costs you 500 TL in Turkey and $1000 in US.
We need to express both suits in the same currency: say $
Real exchange rate
CHAPTER 5 The Open Economy

20. More formally: For a broader basket of goods:
CHAPTER 5 The Open Economy

21. Example one good: Big Mac price in USA: P* = $2.50
price in Turkey: P = TL
nominal exchange rate e = 0.70 $/TL
Price of Big Macs in Turkey are about twice as much as the price in the US.
CHAPTER 5 The Open Economy
slide 20

22. 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
A good candidate for the basket of goods mentioned here is the CPI basket. Perhaps a better candidate would be a basket including all goods & services that comprise GDP. Then, the real exchange rate would measure how many units of foreign GDP trade for one unit of domestic GDP.
CHAPTER 5 The Open Economy

23. Turkey: Real Effective Exchange Rate (1995=100)

24. How NX depends on ε
↑ ε  Domestic goods become more expensive relative to foreign goods
 ↓EX, ↑ IM
 ↓NX
It is important to think of epsilon as the ratio of domestic goods and foreign goods. Domestic goods are converted to foreign currency via the nominal exchange rate in the numerator.
CHAPTER 5 The Open Economy

25. U.S. net exports and the real exchange rate, 1973-20063%
Trade-weighted real exchange rate index
140 2%
120 1%
100 0%
-1%
(March 1973 = 100) 80
(% of GDP)
-2% 60
-3% NX
-4%
Net exports (left scale)
The real exchange rate here is a broad index. Source: Federal Reserve Statistical Release H.10, Board of Governors.
(To find it, simply google “Federal Reserve Statistical Release H.10”)
NX as a percent of GDP was computed from NX and GDP source data from Department of Commerce, Bureau of Economic Analysis, obtained at: 40
Index
-5% 20
-6%
-7%
1973
1977
1981
1985
1989
1993
1997
2001
2005
CHAPTER 5 The Open Economy

26. The net exports function
The net exports function reflects this inverse relationship between NX and ε :
NX = NX(ε )
CHAPTER 5 The Open Economy

27. The NX curve ε ε1 so our net exports will be highNX ε
NX (ε)
NX(ε1)
so our net exports will be high ε1
When ε is relatively low, our goods are relatively inexpensive
Notice that the NX curve is drawn such that it incorporates positive and negative values all in the first quadrant
CHAPTER 5 The Open Economy

28. The NX curve ε2
At high enough values of ε, domestic goods become so expensive that NX ε
NX (ε)
NX(ε2)
we export less than we import
CHAPTER 5 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
In the equation, ε is the only endogenous variable, hence this equation determines the value of ε.
CHAPTER 5 The Open Economy