1. mankiw's macroeconomics modules
A PowerPointTutorial
to Accompany macroeconomics, 5th ed.
N. Gregory Mankiw
Mannig J. Simidian
CHAPTER FIVE
The Open Economy

2. National Income Accounts Identity in an Open Economy
Y = C + I + G + NX
Total demand
for domestic
output
is composed of
Investment
spending by
businesses and
households
Government
purchases of goods
and services
Net exports
or net foreign
demand
Consumption
spending by
households
Notice we’ve added net exports, NX, defined as EX-IM. Also, note that domestic spending on all goods and services is the sum of domestic spending on domestics goods and services and on foreign goods and services.

3. Y = C + I + G + NX NX = Y - (C + I + G)
After some manipulation, the national income accounts identity can be re-written as:
NX = Y - (C + I + G)
Net Exports
Domestic
Spending
Output
This equation shows that in an open economy, domestic spending need
not equal the output of goods and services. If output exceeds domestic
spending, we export the difference: net exports are positive. If output
falls short of domestic spending, we import the difference: net exports
are negative.

4. Net Foreign Investment & the Trade Balance
Start with the national income accounts identity. Y=C+I+G+NX.
Subtract C and G from both sides and obtain Y-C-G = I+NX.
Let’s call this S, national saving.
So, now we have S=I+NX. Subtract I from both sides to obtain the new
equation, S-I=NX.
This form of the national income accounts identity shows that an
economy’s net exports must always equal the difference between its
saving and its investment.
S-I=NX
Trade Balance
Net Foreign Investment

5. Net Capital Outflow = Trade Balance
S-I=NX
If S-I and NX are positive, we have a trade surplus. We would be net
lenders in world financial markets, and we are exporting more
goods than we are importing.
If S-I and NX are negative, we have a trade deficit. We would be net
borrowers in world financial markets, and we are importing more
goods than we are exporting.
If S-I and NX are exactly zero, we have balanced trade since the value
of imports equals the value of exports.

6. Saving and Investment in a Small Open Economy
We are now going to develop a model of the international flows of capital and goods. Then, we’ll address issues such as how the trade balance responds to changes in policy.

7. Capital Mobility and the World Interest Rate
Recall that the trade balance equals the net capital outflow, which
in turn equals saving minus investment, our model focuses on saving
and investment. We’ll borrow a part of the model from Chapter 3, but
won’t assume that the real interest rate equilibrates saving and
investment. Instead, we’ll allow the economy to run a trade deficit
and borrow from other countries, or to run a trade surplus and lend
to other countries.
Consider a small open economy with perfect capital mobility in
which it takes the world interest rate r* as given, denoted r = r*.
Remember in a closed economy, what determines the interest rate is the
equilibrium of domestic saving and investment--and in a way, the world
is like a closed economy-- therefore the equilibrium of world saving and
world investment determines the world interest rate.

8. The Model The economy’s output Y is fixed by the Y = Y = F(K,L)
factors of production and the production
function.
Consumption is positively related to
disposable income (Y-T).
C = C (Y-T)
Investment is negatively related to the
real interest rate.
I = I (r)
NX = (Y-C-G) - I
or NX = S - I
The national income accounts identity,
expressed in terms of saving and investment.
Now substitute our three assumptions from Chapter 3 and the condition
that the interest rate equals the world interest rate, r*.
NX = (Y-C(Y-T) - G) - I (r*)
NX = S I (r*)
This equation suggests that the trade balance is determined by the
difference between saving and investment at the world interest rate.

9. Saving and Investment in a Small Open Economy
I(r)
Investment, Saving, I, S
Real
interest
rate, r*
rclosed
In a closed economy, r adjusts to
equilibrate saving and investment. r* NX
In a small open economy, the
interest rate is set by world
financial markets. The difference
between saving and investment
determines the trade balance.
r*' NX
In this case, since r* is above rclosed and saving exceeds investment,
there is a trade surplus.
If the world interest rate decreased to r* ', I would exceed S and
there would be a trade deficit.

10. A Domestic Fiscal Expansion in a Small Open Economy
An increase in government purchases or a cut in taxes decreases national saving and thus shifts the national saving schedule to the left. S
I(r)
Investment, Saving, I, S
Real
interest
rate, r* r* S'
NX = (Y-C(Y-T) - G) - I (r*)
NX = S I (r*) NX
The result is a reduction in national
saving which leads to a trade deficit,
where I > S.

11. A Fiscal Expansion Abroad in a Small Open Economy
A fiscal expansion in a foreign economy large enough to influence world saving and investment raises the world interest rate
from r1* to r2*. S
I(r)
Investment, Saving, I, S
Real
interest
rate, r*
r1* NX
The higher world interest rate reduces
investment in this small open
economy, causing a trade surplus
where S > I.
r2*

12. A Shift in the Investment Schedule in a Small Open Economy
An outward shift in the investment schedule from I(r)1 to I(r)2 increases the amount of investment at the world interest rate r*. NX
As a result, investment now
exceeds saving I > S, which
means the economy is
borrowing from abroad and
running a trade deficit. S
I(r)1
Investment, Saving, I, S
Real
interest
rate, r*
r1*
I(r)2

13. Exchange Rates In the next few slides, we’ll learn about the foreign
exchange market, exchange rates and much more!

14. The Mechanics of the Foreign Exchange Market
Let’s think about when the US and Japan engage in trade. Each country has different cultures, languages, and currencies, all of which could hinder trade. But, because of the foreign exchange market, trade transactions become more efficient. The foreign exchange market is a global market in which banks are connected through high-tech telecommunications systems in order to purchase currencies for their customers.
The next slide is a graphical representation of the flow of the trade between the U.S. and Japan, and how the mix of traded things might be different, but is always balanced. Also, notice how the foreign exchange market will play the middle-man in these transactions. For instance, the foreign exchange market converts the supply of dollars from the U.S. into the demand for yen, and conversely, the supply of yen into the demand for dollars.

15. Japan U.S. GOODS & SERVICES
In order for the U.S to pay for its imports of goods and services and securities from Japan,
The Foreign
Exchange Market
it must supply dollars which are then converted into yen by the foreign exchange market.
& Securities
GOODS & SERVICES
Japan
U.S.
DemandYEN
Supply$
Foreign
Exchange
Market
SupplyYEN
Demand$
Goods and Services &
SECURITIES
In order for Japan to pay for its imports of goods and services and securities from the U.S.,
it must supply yen which are then converted
into dollars by the foreign exchange market.

16. Exchange Rates Nominal vs. real
The exchange rate between two countries is the price at which
residents of those countries trade with each other.

17. -relative price of the currency of two countries -denoted as e
Nominal Exchange Rate
-relative price of the goods of two countries
-sometimes called the terms of trade
-denoted as e
Real Exchange Rate

18. Nominal Exchange Rate, e
The nominal exchange rate is the relative price of the currency of
two countries. For example, if the exchange rate between the U.S.
dollar and the Japanese yen is 120 yen per dollar, then you can
exchange 1 dollar for 120 yen in world markets for foreign currency.
A Japanese who wants to obtain dollars would pay 120 yen for each
dollar he bought. An American who wants to obtain yen would get
120 yen for each dollar he paid. When people refer to “the exchange
rate” between two countries, they usually mean the nominal exchange
rate.

19. Appreciation and Depreciation
Suppose that there is an increase in the demand for U.S. goods and
services. How will this affect the nominal exchange rate? e
Dollar Value of Transactions D$ A e0 S$ $
D$ 
D$ shifts rightward and increases the nominal exchange rate, e. This is known as appreciation of the dollar. B e1
Events which decrease the demand for the dollar, and thus decrease e would be a depreciation of the dollar.

20. Real Exchange Rate, e
The real exchange rate is the relative price of the goods of two countries. That is, the real exchange rate tells us the rate at which we can trade the goods of one country for the goods of another.
To see the difference between the real and nominal exchange rates,
consider a single good produced in many countries: cars. Suppose an
American car costs $10,000 and a similar Japanese car costs 2,400,000
yen. To compare the prices of the two cars, we must convert them into
a common currency. If a dollar is worth 120 yen, then the American
car costs 1,200,000 yen. Comparing the price of the American car
(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), we
conclude that the American car costs one-half of what the Japanese
car costs. In other words, at current prices, we can exchange 2
American cars for 1 Japanese car.

21. e Real Exchange Rate, We can summarize our calculation as follows:
Real Exchange Rate = (120 yen/dollar)  (10,000 dollars/American car)
(2,400,000 yen/Japanese Car)
= 0.5 Japanese Car
American Car
At these prices, and this exchange rate, we obtain one-half of a Japanese
car per American car. More generally, we can write this calculation as Real Exchange Rate =
Nominal Exchange Rate  Price of Domestic Good
Price of Foreign Good
The rate at which we exchange foreign and domestic goods depends on
the prices of the goods in the local currencies and on the rate at which
the currencies are exchanged.

22. Relationship between the real and nominal exchange rate
e = e × (P/P*)
Nominal Exchange
Rate
Real Exchange
Rate
Ratio of Price
Levels
Note: P is the price level of the domestic country (measured
in the domestic currency) and P* is the price level of the
foreign country (measured in the foreign currency).

23. e = e × (P/P*) Real Exchange Rate Nominal Exchange Rate Ratio of Price
Levels
The real exchange rate between two countries is computed from the nominal exchange rate and the price levels in the two countries. If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. If the real exchange rate is low, foreign goods are relatively expensive, and domestic goods
are relatively cheap.

24. Purchasing Power Parity
How does the level of prices effect exchange rates? It doesn’t. All changes in a nation’s price level will be fully incorporated into the nominal exchange rate. It is the law of one price applied to the international marketplace.
Purchasing Power Parity suggests that nominal exchange rate movements primarily reflect differences in price levels of nations. It states that if international arbitrage is possible, then a dollar must have the same purchasing power in every country. Purchasing Power Parity does not always hold because some goods are not easily traded, and sometimes traded goods are not always perfect substitutes– but it does give us reason to expect that fluctuations in the real exchange rate will be small and short-lived.

25. Purchasing Power Parity
The law of one price applied to the
international marketplace suggests that
net exports are highly sensitive to small
movements in the real exchange rate.
This high sensitivity is reflected here
with a very flat net-exports schedule.
Real
exchange
rate, e
S-I
NX(e)
Net Exports, NX

26. The Real Exchange Rate and the Trade Balance
The relationship between the real exchange rate and net exports is negative: the lower the real exchange rate, the less expensive are domestic goods relative to foreign goods, and thus the greater are our net exports.
NX(e)
Net Exports, NX
Real
exchange
rate, e
The real exchange rate is determined by the
intersection of the vertical line representing
saving minus investment and downward-sloping
net exports schedule.
S-I
Here the quantity of dollars
supplied for net foreign
investment equals the
quantity of dollars demanded
for the net exports of goods
and services.

27. The Impact of Expansionary Fiscal Policy at Home on the Real Exchange Rate
Net Exports, NX
Real
exchange
rate, e
NX1
The fall in saving reduces the supply of dollars
to be exchanged into foreign currency, from
S1-I to S2-I. This shift raises the equilibrium real
exchange rate from e1 to e2.
S1-I
Expansionary fiscal policy at home, such as an
increase in government purchases G or a cut in
taxes, reduces national saving. e2 e1
NX(e)
A reduction in saving reduces
the supply of dollars which
causes the real exchange rate
to rise and causes net exports
to fall.
NX2

28. The Impact of Expansionary Fiscal Policy Abroad on the Real Exchange Rate
The increase in the world interest rate reduces
investment at home, which in turn raises the
supply of dollars to be exchanged into foreign
currencies.
S-I (r2*)
Expansionary fiscal policy abroad reduces world saving and raises the world interest rate from r1* to r2*.
NX(e)
Net Exports, NX
Real
exchange
rate, e
NX2
S-I(r1*) e1 e2
As a result, the equilibrium
real exchange rate falls from
e1 to e2.
NX1

29. The Impact of an Increase in Investment Demand on the Real Exchange Rate
As a result, the supply of dollars to be
exchanged into foreign currencies falls
from S-I1 to S-I2.
S-I1
An increase in investment demand raises the quantity of domestic investment from I1
to I2.
NX(e)
Net Exports, NX
Real
exchange
rate, e
NX1
S-I2 e2
This fall in supply raises the equilibrium real exchange rate from e1 to e2. e1
NX2

30. Key Concepts of Ch. 5 Net exports Trade balance Net capital outflow
Trade surplus and trade deficit
Balanced trade
Small open economy
World interest rate
Nominal exchange rate
Real exchange rate
Purchasing-power parity