1. Ohio Wesleyan University Goran Skosples 6. The Open Economy

2. 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

3. Key Concepts Net exports Trade balance Capital mobility
Net capital outflow
Small open economy
World interest rate
Nominal exchange rate
Real exchange rate
Purchasing power parity
Trade policy
Large open economy

4. Imports and exports of selected countries, 2011
In dollar terms, U.S. trade is huge, but as a percentage of GDP, it is smaller than that of many other countries.
source: World Development Indicators, World Bank

5. In an open economy, spending need not equal _______
saving need not equal ___________
EX = exports = foreign spending on domestic goods
IM = imports = domestic spending on foreign goods
NX = net exports (a.k.a. the “trade balance”) = EX – IM

6. The national income identity in an open economy
Y = C + I + G + NX
or, NX = Y – (C + I + G )
net exports
trade surplus: output __ spending and EX __ IM
trade deficit: spending __ output and IM __ EX

7. 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 _________
When S < I, country is a ____________

8. The link between trade & cap. flows
NX = Y – (C + I + G )
implies
NX = =
Thus, a country with a trade deficit (NX < 0) is a net ____________ (S < I ).

9. Saving, investment, and the trade balance 1960–2013
Notice that investment > saving pretty consistently beginning in the early 1980s.
The trade balance is measured on the right-hand scale; note that the location of 0% is different on the two scales.
source: Federal Reserve Bank of St. Louis
notes:
Investment was constructed as the sum of Gross Private Domestic Investment (GPDI), Federal Government Defense Investment (DGI), Federal Government Nondefense Investment (NDGI), and State & Local Investment (SLINV).
Saving is simply Gross Saving (GSAVE). The Trade Balance was constructed as saving minus investment.
trade balance (right scale)

10. 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
consumption function
investment function
exogenous policy variables

11. National saving: The supply of loanable fundsr
S, I
As in Chapter 3, national saving ____ ____depend on the interest rate

12. Assumptions re: Capital flows
a. domestic & foreign bonds are perfect ________ (same risk, maturity, etc.)
b. perfect capital _________: no restrictions on international trade in assets
c. economy is ______: cannot affect the world interest rate, denoted r*
a & b imply _____
c implies r* is __________

13. Investment: The demand for loanable funds
Investment is still a _________-sloping function of the interest rate, r
S, I
but the exogenous world interest rate…
…determines the country’s level of ___________.

14. If the economy were closed…
S, I
I (r )

15. Point
Trade balance is determined by saving and investment at the world interest rate. r* r
S, I
I (r )
I (r ) r
S, I r*
when S I the
country ____ K ___ the rest of the world
when S __ I the
country ______ K ____ the rest of the world

16. Three experiments: Fiscal policy at home Fiscal policy abroad
An increase in investment demand

17. 1. Fiscal policy at home r S, I I (r )
An increase in G or decrease in T _______ saving.
I (r )
Results:

18. NX and the federal budget deficit (% of GDP), 1965–2013
Budget deficit (left scale)
Our model implies a negative relationship between NX and the budget deficit. We observe this negative relationship during most periods.
There are some exceptions. For example, from 1991 to 2001, NX and the budget deficit fell, due to a long expansion: rising incomes increased imports and tax revenues.
And, in , NX and the budget deficit rose as the economy faltered: falling incomes reduce both tax revenue and imports.
Source: Department of Commerce.
Obtained from:
Net exports (right scale)

19. 2. Fiscal policy abroad r S, I I (r )
Expansionary fiscal policy abroad _____ the world interest rate.
NX1
Results:

20. 3. An increase in investment demand
S, I S
ANSWERS:
I ,
S ,
net capital outflow and NX ________ ___________ ___________
I (r )1
I 1
NX1

21. Two exchange rates
e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency
(e.g. Yen per Dollar)
ε = real exchange rate, the relative price of domestic goods in terms of foreign goods
(e.g. Japanese Big Macs per U.S. Big Mac)

22. Understanding the units of ε

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 buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy __ Japanese Big Macs. 22

24. The net exports function
How NX depends on ε
ε  U.S. goods become more expensive relative to foreign goods
 EX, IM
 NX
The net exports function
The net exports function reflects this inverse relationship between NX and ε :
NX =

25. U.S. net exports and the real exchange rate, 1973–2012
Trade-weighted real exchange rate index
(March 1973 = 100)
(% of GDP) NX
Index
Net exports (left scale)
The real exchange rate here is a broad index. Source: Federal Reserve Statistical Release H.10, Board of Governors.
NX as a percent of GDP was computed from NX and GDP source data from Department of Commerce, Bureau of Economic Analysis, obtained at:
The RER data are monthly and the NX and Y data are quarterly, so the RER series shown in the graph is a quarterly series where each value is an average of the three monthly values from that quarter.

26. The NX curve for the U.S. NX ε
NX (ε)

27. 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

28. How ε is determined
Neither S nor I depend on ε, so the net capital outflow curve is _____. ε NX
NX(ε )
ε 1
ε adjusts to ________ NX with net capital outflow, _____.

29. Four experiments: Fiscal policy at home Fiscal policy abroad
An increase in investment demand
Trade policy to restrict imports

30. 1. Fiscal policy at home
↑ G  ε NX
NX(ε )
ε 1
NX 1

31. 2. Fiscal policy abroad
↑ G abroad  ε NX
NX(ε )
NX 1
ε 1

32. 3. Increase in investment demand ε NX
NX 1
NX(ε )
ε 1

33. 4. Trade policy to restrict imports
At any given value of ε, an import quota
 IM  NX
 demand for dollars _____ ______ ε NX
NX (ε )1
NX1
ε 1
Trade policy ______ affect S or I , so capital flows and the supply of dollars ____________.

34. The determinants of the nominal exchange rate
Start with the expression for the real exchange rate:
Solve for the nominal exchange rate: 33

35. 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: 34

36. The determinants of the nominal exchange rate
Rewrite this equation in growth rates (recall “arithmetic tricks for working with % changes”)
For a given value of ε, the growth rate of e equals the difference between ____________________________. 35

37. Inflation differentials and nominal exchange rates for a cross section of countries
% change in nominal exchange rate
Iceland
Pakistan
Mexico
U.K.
S. Africa
Sweden
S. Korea
Japan
Denmark
Figure 6-13 on p The horizontal axis measures the country’s inflation rate minus the U.S. inflation rate. The vertical axis measures the percentage change in the U.S. dollar exchange rate with that country (positive values mean the country’s currency depreciates relative to the dollar). All variables are annual averages over the period
This figure shows a positive relationship between the inflation differential and the rate of dollar appreciation: The higher a country’s inflation relative to U.S. inflation, the faster the U.S. dollar will appreciate against that country’s currency.
Source: International Financial Statistics
Note: Due to space constraints on this slide, Norway’s point is not labeled; it is virtually identical to Canada’s point.
Canada
Singapore
Australia
Switzerland
New Zealand
inflation differential

38. Purchasing Power Parity (PPP)
If international arbitrage is possible, then $ must have the same purchasing power in every country
__ equalizes purchasing power:
Does PPP hold in the real world?
No entirely, for two reasons:
International arbitrage not possible.
Goods of different countries not __________ ________________.
Why is PPP then important?

39. CASE STUDY: The Reagan deficits revisited
closed economy
small open economy
actual change ε NX I r S
G – T
1980s
1970s
115.1
-0.3
19.9
1.1
19.6
2.2
129.4
-2.0
19.4
6.3
17.4
3.9  
Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index. 38

40. The U.S. as a large open economy
So far, we’ve learned long-run models for two extreme cases:
closed economy (chap. 3)
small open economy (chap. 5)
A large open economy – like the U.S. – falls ___________ these two extremes.
The results from large open economy analysis are a ___________ of the results for the closed & small open economy cases.
For example… 39

41. A fiscal expansion in three models
A fiscal expansion causes national saving to fall. The effects of this depend on openness & size: NX I r
large open economy
small open economy
closed economy 40

42. 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
National income accounts identities:
Y = C + I + G + NX
trade balance NX = S - I net capital outflow

43. 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
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.

44. 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