National Income & Business Cycles

1

Ohio Wesleyan UniversityGoran Skosples

6. The Open Economy

2

Objectives

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

3Australia China Germany Greece S. Korea Mexico United

States

0

10

20

30

40

50

60

Exports Imports

Perc

ent o

f GD

PImports and exports of selected

countries, 2011

4

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

5

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

6

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 ____________

7

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 ).

81960 1965 1970 1975 1980 1985 1990 1995 2000 2005 20100%

5%

10%

15%

20%

25%

-10%

-5%

0%

5%

10%

15%

Sav

ing,

Inve

stm

ent (

% o

f GD

P)

Trad

e B

alan

ce (%

of G

DP

)

Saving, investment, and the trade balance 1960–2013

trade balance (right scale)

saving

investment

9

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

Y Y F K L ( , )C C Y T ( )

I I r ( )G G T T ,

10

National saving: The supply of loanable funds

r

S, I

As in Chapter 3,national saving ____ ____depend on the

interest rate

11

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 __________

12

Investment: The demand for loanable

fundsInvestment is still a _________-sloping function of the interest rate,

but the exogenous world interest rate…

…determines the country’s level of ___________.

r

S, I

13

If the economy were closed…

r

S, I

I (r )

S

14

Point

r*

r

S, I

I (r )

S S

I (r )

r

S, I

r*

when S I the country ____ K ___ the rest of the world

Trade balance is determined by saving and investment at the world interest rate.

when S __ I the country ______ K ____ the rest of the world

15

Three experiments:

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

16

1. Fiscal policy at homer

S, I

I (r )

1SAn increase in G or decrease in T _______ saving.

Results: 0I

0NX S

171965 1970 1975 1980 1985 1990 1995 2000 2005 2010

-4%

-2%

0%

2%

4%

6%

8%

10%

-6%

-4%

-2%

0%

2%

NX and the federal budget deficit (% of GDP), 1965–2013

Budget deficit (left scale)

Net exports

(right scale)

18

2. Fiscal policy abroadr

S, I

I (r )

1SExpansionary fiscal policy abroad _____ the world interest rate. 1

*rNX1

Results: 0I

0NX I

1( )*I r

19

3. An increase in investment demand

r

S, I

I (r )1

ANSWERS: I , S ,net capital outflow and NX ________ ___________ ___________

NX1

*r

I 1

S

20

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)

21

Understanding the units of ε

(Yen per $) ($ per unit U.S. goods)Yen per unit Japanese goods

Units of Japanese goods

per unit of U.S. goods

Yen per unit U.S. goodsYen per unit Japanese goods

*e PPε

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.

~ McZample ~

22

23

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 =

241970.001975.751981.501987.251993.001998.752004.502010.25

-8%

-6%

-4%

-2%

0%

2%

4%

0

20

40

60

80

100

120

140

U.S. net exports and the real exchange rate, 1973–2012

NX

(% o

f GD

P)

Inde

x (M

arch

197

3 =

100)

Trade-weighted real exchange rate index

Net exports(left scale)

25

The NX curve for the U.S.

0 NX

ε

NX

(ε)

26

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

27

How ε is determinedNeither S nor I depend on ε, so the net capital outflow curve is _____.

ε

NX

NX(ε

)ε adjusts to ________ NX with net capital outflow, _____.

ε 1

28

Four experiments:

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

4. Trade policy to restrict imports

29

1. Fiscal policy at home

ε

NX

NX(ε

)

1 ( *)S I r

ε 1

NX 1

↑ G

30

2. Fiscal policy abroad

ε

NX

NX(ε

)

1 1( *)S I r

NX 1

ε 1

↑ G abroad

31

3. Increase in investment demand

ε

NX

NX(ε

)

ε 1

1 1S I

NX 1

↑ I

32

4. Trade policy to restrict imports

ε

NX

NX (ε )1

S I

NX1

ε 1

At any given value of ε, an import quota

IM NX

demand for

dollars _____ ______ Trade policy ______

affect S or I , so capital flows and the supply of dollars ____________.

33

The determinants of the nominal exchange rate

Start with the expression for the real exchange rate:

*e PεP

Solve for the nominal exchange rate:

34

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:

*Pe εP

35

The determinants of the nominal exchange rate

Rewrite this equation in growth rates (recall “arithmetic tricks for working with % changes”)

*Pe εP

For a given value of ε, the growth rate of e equals the difference between ____________________________.

36

-4% -2% 0% 2% 4% 6% 8%-6%

-4%

-2%

0%

2%

4%

6%

8%

Inflation differentials and nominal exchange rates for a cross section of

countries% change in nominal exchange

rate

inflation differential

Pakistan

U.K.

Singapore

Switzerland

Japan

Sweden

Iceland

Mexico

S. KoreaS. Africa

Australia

CanadaDenmark

New Zealand

37

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:1. International arbitrage not possible.

- -

2. Goods of different countries not __________ ________________.

Why is PPP then important?

38

129.4

-2.0

19.4

6.3

17.4

3.9

115.1

-0.3

19.9

1.1

19.6

2.2

closed economy

small open economy

actual change

ε

NX

I

r

S

G – T

1980s1970s

Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index.

CASE STUDY: The Reagan deficits revisited

39

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…

40

NX

I

r

large open economy

small open economy

closed economy

A fiscal expansion in three models

A fiscal expansion causes national saving to fall.The effects of this depend on openness & size:

41

Summary

1. Net exports--the difference between • exports and imports• a country’s output (Y )

and its spending (C + I + G)

2. Net capital outflow equals• purchases of foreign assets

minus foreign purchases of the country’s assets• the difference between saving and investment

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

42

Summary

4. 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

5. 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.

43

Summary

7. 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