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This document provides an overview of macroeconomic concepts related to open economies. It begins with chapter objectives about accounting identities, the small open economy model, and how policies affect trade balances and exchange rates. It then presents preliminary concepts like imports, exports, the trade balance, and how GDP is determined in an open economy. The rest of the document uses graphs and equations to explain key ideas like the determinants of investment, saving, and net capital flows in a small open economy. It also analyzes how fiscal policy, investment changes, and exchange rates impact trade balances. The document concludes by explaining how nominal exchange rates are determined based on real exchange rates and domestic and foreign price levels.

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macroeconomics fifth edition N. Gregory Mankiw PowerPoint® Slides by Ron Cronovich macro © 2002 Worth Publishers, all rights reserved CHAPTER FIVE The Open Economy
CHAPTER 5 The Open Economy slide 1 Chapter objectives  accounting identities for the open economy  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 5 The Open Economy slide 2 Percentage of GDP 40 35 30 25 20 15 10 5 0 Canada France Germany Italy Japan U.K. U.S. Imports Exports Imports and Exports as a percentage of output: 2000
CHAPTER 5 The Open Economy slide 3 In an open economy,  spending need not equal output  saving need not equal investment
CHAPTER 5 The Open Economy slide 4 Preliminaries EX = exports = foreign spending on domestic goods IM = imports = Cf + If + Gf = spending on foreign goods d f C C C   d f I I I   d f G G G   superscripts: d = spending on domestic goods f = spending on foreign goods
CHAPTER 5 The Open Economy slide 5 Preliminaries, cont. NX = net exports (a.k.a. the “trade balance”) = EX – IM  If NX > 0, country has a trade surplus equal to NX  If NX < 0, country has a trade deficit equal to –NX
CHAPTER 5 The Open Economy slide 6 GDP = expenditure on domestically produced g & s d d d Y C I G EX     ( ) ( ) ( ) f f f C C I I G G EX        ( ) f f f C I G EX C I G        C I G EX IM      C I G NX    
CHAPTER 5 The Open Economy slide 7 The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G) net exports domestic spending output
CHAPTER 5 The Open Economy slide 8 International capital flows  Net capital outflows = 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 net lender  When S < I, country is a net borrower
CHAPTER 5 The Open Economy slide 9 Another important identity NX = Y – (C + I + G) implies NX = (Y – C – G) – I = S – I trade balance = net capital outflows
CHAPTER 5 The Open Economy slide 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: ( , ) Y Y F K L   consumption function: ( ) C C Y T   investment function: ( ) I I r  exogenous policy variables: , G G T T  
CHAPTER 5 The Open Economy slide 11 National Saving: The Supply of Loanable Funds r S, I As in Chapter 3, national saving does not depend on the interest rate ( ) S Y C Y T G     S
CHAPTER 5 The Open Economy slide 12 Assumptions re: 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 5 The Open Economy slide 13 Investment: The Demand for Loanable Funds Investment is still a downward-sloping function of the interest rate, r* but the exogenous world interest rate… …determines the country’s level of investment. I(r*) r S, I I(r)
CHAPTER 5 The Open Economy slide 14 If the economy were closed… r S, I I(r) S rc ( ) c I r S  …the interest rate would adjust to equate investment and saving:
CHAPTER 5 The Open Economy slide 15 But in a small open economy… r S, I I(r) S rc r* I1 the exogenous world interest rate determines investment… …and the difference between saving and investment determines net capital outflows and net exports NX
CHAPTER 5 The Open Economy slide 16 Three experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand
CHAPTER 5 The Open Economy slide 17 1. Fiscal policy at home r S, I I(r) 1 S I1 An increase in G or decrease in T reduces saving. 1 * r NX1 2 S NX2 Results: 0 I   0 NX S    
CHAPTER 5 The Open Economy slide 18 NX and the Government Budget Deficit -4 -3 -2 -1 0 1 2 3 4 1950 1960 1970 1980 1990 2000 Percent of GDP -8 -6 -4 -2 0 2 4 6 8 Percent of GDP Budget deficit (right scale) Net exports (left scale)
CHAPTER 5 The Open Economy slide 19 2. Fiscal policy abroad r S, I I(r) 1 S Expansionary fiscal policy abroad raises the world interest rate. 1 * r NX1 NX2 Results: 0 I   0 NX I     2 * r 1 ( ) * I r 2 ( ) * I r
CHAPTER 5 The Open Economy slide 20 3. An increase in investment demand r S, I I(r)1 EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. NX1 * r I1 S
CHAPTER 5 The Open Economy slide 21 3. An increase in investment demand r S, I I(r)1 ANSWERS: I > 0, S = 0, net capital outflows and net exports fall by the amount I NX2 NX1 * r I1 I2 S I(r)2
CHAPTER 5 The Open Economy slide 22 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 5 The Open Economy slide 23 Exchange rates as of June 6, 2002 country exchange rate Euro 1.06 Euro/$ Japan 124.3 Yen/$ Mexico 9.7 Pesos/$ Russia 31.4 Rubles/$ South Africa 9.8 Rand/$ Turkey 1,444,063.1 Liras/$ U.K. 0.68 Pounds/$
CHAPTER 5 The Open Economy slide 24 The real exchange rate = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac) the lowercase Greek letter epsilon ε
CHAPTER 5 The Open Economy slide 25 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. goods Yen per unit Japanese goods  * e P P   ε
CHAPTER 5 The Open Economy slide 26  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 1.5 Japanese Big Macs. * 120 $2.50 200 Y . en 1 5 e P P      ε ~ McZample ~
CHAPTER 5 The Open Economy slide 27 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 5 The Open Economy slide 28 How NX depends on ε ε  U.S. goods become more expensive relative to foreign goods  EX, IM  NX
CHAPTER 5 The Open Economy slide 29 U.S. Net Exports and the Real Exchange Rate, 1975-2002 -5 -4 -3 -2 -1 0 1 2 1975 1980 1985 1990 1995 2000 Percent of GDP 0 20 40 60 80 100 120 140 1998:2 = 100 Net exports (left scale) Real exchange rate (right scale)
CHAPTER 5 The Open Economy slide 30 The net exports function  The net exports function reflects this inverse relationship between NX and ε: NX = NX(ε)
CHAPTER 5 The Open Economy slide 31 The NX curve for the U.S. 0 NX ε NX(ε) ε1 When ε is relatively low, U.S. goods are relatively inexpensive NX(ε1) so U.S. net exports will be high
CHAPTER 5 The Open Economy slide 32 The NX curve for the U.S. 0 NX ε NX(ε) ε2 At high enough values of ε, U.S. goods become so expensive that NX(ε2) we export less than we import
CHAPTER 5 The Open Economy slide 33 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 5 The Open Economy slide 34 How ε is determined Neither S nor I depend on ε, so the net capital outflow curve is vertical. ε NX NX(ε) 1 ( *) S I r  ε adjusts to equate NX with net capital outflow, S  I. ε1 NX1
CHAPTER 5 The Open Economy slide 35 Interpretation: supply and demand in the foreign exchange market demand: Foreigners need dollars to buy U.S. net exports. ε NX NX(ε) 1 ( *) S I r  supply: The net capital outflow (S  I) is the supply of dollars to be invested abroad. ε1 NX1
CHAPTER 5 The Open Economy slide 36 Four experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports
CHAPTER 5 The Open Economy slide 37 1. Fiscal policy at home A fiscal expansion reduces national saving, net capital outflows, and the supply of dollars in the foreign exchange market… …causing the real exchange rate to rise and NX to fall. ε NX NX(ε) 1 ( *) S I r  ε1 NX1 NX2 2 ( *) S I r  ε2
CHAPTER 5 The Open Economy slide 38 2. Fiscal policy abroad An increase in r* reduces investment, increasing net capital outflows and the supply of dollars in the foreign exchange market… …causing the real exchange rate to fall and NX to rise. ε NX NX(ε) 1 1 ( *) S I r  NX1 ε1 2 1 ( ) * S I r  ε2 NX2
CHAPTER 5 The Open Economy slide 39 3. An increase in investment demand An increase in investment reduces net capital outflows and the supply of dollars in the foreign exchange market… ε NX NX(ε) …causing the real exchange rate to rise and NX to fall. ε1 1 1 S I  NX1 2 1 S I  NX2 ε2
CHAPTER 5 The Open Economy slide 40 4. Trade policy to restrict imports ε NX NX(ε)1 S I  NX1 ε1 NX(ε)2 At any given value of ε, an import quota  IM  NX  demand for dollars shifts right Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remains fixed. ε2
CHAPTER 5 The Open Economy slide 41 4. Trade policy to restrict imports ε NX NX(ε)1 S I  NX1 ε1 NX(ε)2 Results: ε > 0 (demand increase) NX = 0 (supply fixed) IM < 0 (policy) EX < 0 (rise in ε ) ε2
CHAPTER 5 The Open Economy slide 42 The Determinants of the Nominal Exchange Rate  Start with the expression for the real exchange rate: * e P ε P    Solve it for the nominal exchange rate: * P e ε P  
CHAPTER 5 The Open Economy slide 43 The Determinants of the Nominal Exchange Rate ( * , ) M L r Y P   ( ) ( ) * NX ε S I r    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: * P e ε P   * * * * ( * *, ) M L r Y P   
CHAPTER 5 The Open Economy slide 44 The Determinants of the Nominal Exchange Rate  We can rewrite this equation in terms of growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ): * P e ε P   * * e ε P P e ε P P        * ε ε        For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates.
CHAPTER 5 The Open Economy slide 45 Inflation and nominal exchange rates Percentage change in nominal exchange rate 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 Inflation differential Depreciation relative to U.S. dollar Appreciation relative to U.S. dollar -1 -2 -3 1 0 2 3 4 5 6 8 7 France Canada Sweden Australia UK Ireland Spain South Africa Italy New Zealand Netherlands Germany Japan Belgium Switzerland
CHAPTER 5 The Open Economy slide 46 Purchasing Power Parity (PPP)  def1: a doctrine that states that goods must sell at the same (currency-adjusted) price in all countries.  def2: the nominal exchange rate adjusts to equalize the cost of a basket of goods across countries.  Reasoning: arbitrage, the law of one price
CHAPTER 5 The Open Economy slide 47 Purchasing Power Parity (PPP)  PPP: e P = P* Cost of a basket of domestic goods, in foreign currency. Cost of a basket of domestic goods, in domestic currency. Cost of a basket of foreign goods, in foreign 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 5 The Open Economy slide 48 Purchasing Power Parity (PPP)  If e = P*/P, then * * * 1 P P P ε e P P P      and the NX curve is horizontal: ε NX NX ε = 1 S  I Under PPP, changes in (S  I ) have no impact on ε or e.
CHAPTER 5 The Open Economy slide 49 Does PPP hold in the real world? No, for two reasons: 1. International arbitrage not possible.  nontraded goods  transportation costs 2. Goods of different countries not perfect substitutes. Nonetheless, PPP is a useful theory: • It’s simple & intuitive • In the real world, nominal exchange rates have a tendency toward their PPP values over the long run.
CHAPTER 5 The Open Economy slide 50 no change no change       no change no change         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 1980s 1970s 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
CHAPTER 5 The Open Economy slide 51 The U.S. as a large open economy  So far, we’ve learned long-run models for two extreme cases:  closed economy (chapter 3)  small open economy (chapter 5)  A large open economy---like the U.S.---is in between these two extremes.  The analysis of policies or other exogenous changes in a large open economy is a mixture of the results for the closed & small open economy cases.  For example…
CHAPTER 5 The Open Economy slide 52 NX I r large open economy small open economy closed economy A fiscal expansion in three models falls, but not as much as in small open economy falls no change falls, but not as much as in closed economy no change falls rises, but not as much as in closed economy no change rises A fiscal expansion causes national saving to fall. The effects of this depend on the degree of openness:
CHAPTER 5 The Open Economy slide 53 Chapter 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
CHAPTER 5 The Open Economy slide 54 Chapter 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.
CHAPTER 5 The Open Economy slide 55 Chapter summary 6. 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 7. 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 5 The Open Economy slide 56

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ch05[1].ppt

  • 1. macroeconomics fifth edition N. Gregory Mankiw PowerPoint® Slides by Ron Cronovich macro © 2002 Worth Publishers, all rights reserved CHAPTER FIVE The Open Economy
  • 2. CHAPTER 5 The Open Economy slide 1 Chapter objectives  accounting identities for the open economy  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. CHAPTER 5 The Open Economy slide 2 Percentage of GDP 40 35 30 25 20 15 10 5 0 Canada France Germany Italy Japan U.K. U.S. Imports Exports Imports and Exports as a percentage of output: 2000
  • 4. CHAPTER 5 The Open Economy slide 3 In an open economy,  spending need not equal output  saving need not equal investment
  • 5. CHAPTER 5 The Open Economy slide 4 Preliminaries EX = exports = foreign spending on domestic goods IM = imports = Cf + If + Gf = spending on foreign goods d f C C C   d f I I I   d f G G G   superscripts: d = spending on domestic goods f = spending on foreign goods
  • 6. CHAPTER 5 The Open Economy slide 5 Preliminaries, cont. NX = net exports (a.k.a. the “trade balance”) = EX – IM  If NX > 0, country has a trade surplus equal to NX  If NX < 0, country has a trade deficit equal to –NX
  • 7. CHAPTER 5 The Open Economy slide 6 GDP = expenditure on domestically produced g & s d d d Y C I G EX     ( ) ( ) ( ) f f f C C I I G G EX        ( ) f f f C I G EX C I G        C I G EX IM      C I G NX    
  • 8. CHAPTER 5 The Open Economy slide 7 The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G) net exports domestic spending output
  • 9. CHAPTER 5 The Open Economy slide 8 International capital flows  Net capital outflows = 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 net lender  When S < I, country is a net borrower
  • 10. CHAPTER 5 The Open Economy slide 9 Another important identity NX = Y – (C + I + G) implies NX = (Y – C – G) – I = S – I trade balance = net capital outflows
  • 11. CHAPTER 5 The Open Economy slide 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: ( , ) Y Y F K L   consumption function: ( ) C C Y T   investment function: ( ) I I r  exogenous policy variables: , G G T T  
  • 12. CHAPTER 5 The Open Economy slide 11 National Saving: The Supply of Loanable Funds r S, I As in Chapter 3, national saving does not depend on the interest rate ( ) S Y C Y T G     S
  • 13. CHAPTER 5 The Open Economy slide 12 Assumptions re: 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
  • 14. CHAPTER 5 The Open Economy slide 13 Investment: The Demand for Loanable Funds Investment is still a downward-sloping function of the interest rate, r* but the exogenous world interest rate… …determines the country’s level of investment. I(r*) r S, I I(r)
  • 15. CHAPTER 5 The Open Economy slide 14 If the economy were closed… r S, I I(r) S rc ( ) c I r S  …the interest rate would adjust to equate investment and saving:
  • 16. CHAPTER 5 The Open Economy slide 15 But in a small open economy… r S, I I(r) S rc r* I1 the exogenous world interest rate determines investment… …and the difference between saving and investment determines net capital outflows and net exports NX
  • 17. CHAPTER 5 The Open Economy slide 16 Three experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand
  • 18. CHAPTER 5 The Open Economy slide 17 1. Fiscal policy at home r S, I I(r) 1 S I1 An increase in G or decrease in T reduces saving. 1 * r NX1 2 S NX2 Results: 0 I   0 NX S    
  • 19. CHAPTER 5 The Open Economy slide 18 NX and the Government Budget Deficit -4 -3 -2 -1 0 1 2 3 4 1950 1960 1970 1980 1990 2000 Percent of GDP -8 -6 -4 -2 0 2 4 6 8 Percent of GDP Budget deficit (right scale) Net exports (left scale)
  • 20. CHAPTER 5 The Open Economy slide 19 2. Fiscal policy abroad r S, I I(r) 1 S Expansionary fiscal policy abroad raises the world interest rate. 1 * r NX1 NX2 Results: 0 I   0 NX I     2 * r 1 ( ) * I r 2 ( ) * I r
  • 21. CHAPTER 5 The Open Economy slide 20 3. An increase in investment demand r S, I I(r)1 EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. NX1 * r I1 S
  • 22. CHAPTER 5 The Open Economy slide 21 3. An increase in investment demand r S, I I(r)1 ANSWERS: I > 0, S = 0, net capital outflows and net exports fall by the amount I NX2 NX1 * r I1 I2 S I(r)2
  • 23. CHAPTER 5 The Open Economy slide 22 The nominal exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar)
  • 24. CHAPTER 5 The Open Economy slide 23 Exchange rates as of June 6, 2002 country exchange rate Euro 1.06 Euro/$ Japan 124.3 Yen/$ Mexico 9.7 Pesos/$ Russia 31.4 Rubles/$ South Africa 9.8 Rand/$ Turkey 1,444,063.1 Liras/$ U.K. 0.68 Pounds/$
  • 25. CHAPTER 5 The Open Economy slide 24 The real exchange rate = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac) the lowercase Greek letter epsilon ε
  • 26. CHAPTER 5 The Open Economy slide 25 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. goods Yen per unit Japanese goods  * e P P   ε
  • 27. CHAPTER 5 The Open Economy slide 26  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 1.5 Japanese Big Macs. * 120 $2.50 200 Y . en 1 5 e P P      ε ~ McZample ~
  • 28. CHAPTER 5 The Open Economy slide 27 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
  • 29. CHAPTER 5 The Open Economy slide 28 How NX depends on ε ε  U.S. goods become more expensive relative to foreign goods  EX, IM  NX
  • 30. CHAPTER 5 The Open Economy slide 29 U.S. Net Exports and the Real Exchange Rate, 1975-2002 -5 -4 -3 -2 -1 0 1 2 1975 1980 1985 1990 1995 2000 Percent of GDP 0 20 40 60 80 100 120 140 1998:2 = 100 Net exports (left scale) Real exchange rate (right scale)
  • 31. CHAPTER 5 The Open Economy slide 30 The net exports function  The net exports function reflects this inverse relationship between NX and ε: NX = NX(ε)
  • 32. CHAPTER 5 The Open Economy slide 31 The NX curve for the U.S. 0 NX ε NX(ε) ε1 When ε is relatively low, U.S. goods are relatively inexpensive NX(ε1) so U.S. net exports will be high
  • 33. CHAPTER 5 The Open Economy slide 32 The NX curve for the U.S. 0 NX ε NX(ε) ε2 At high enough values of ε, U.S. goods become so expensive that NX(ε2) we export less than we import
  • 34. CHAPTER 5 The Open Economy slide 33 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  
  • 35. CHAPTER 5 The Open Economy slide 34 How ε is determined Neither S nor I depend on ε, so the net capital outflow curve is vertical. ε NX NX(ε) 1 ( *) S I r  ε adjusts to equate NX with net capital outflow, S  I. ε1 NX1
  • 36. CHAPTER 5 The Open Economy slide 35 Interpretation: supply and demand in the foreign exchange market demand: Foreigners need dollars to buy U.S. net exports. ε NX NX(ε) 1 ( *) S I r  supply: The net capital outflow (S  I) is the supply of dollars to be invested abroad. ε1 NX1
  • 37. CHAPTER 5 The Open Economy slide 36 Four experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports
  • 38. CHAPTER 5 The Open Economy slide 37 1. Fiscal policy at home A fiscal expansion reduces national saving, net capital outflows, and the supply of dollars in the foreign exchange market… …causing the real exchange rate to rise and NX to fall. ε NX NX(ε) 1 ( *) S I r  ε1 NX1 NX2 2 ( *) S I r  ε2
  • 39. CHAPTER 5 The Open Economy slide 38 2. Fiscal policy abroad An increase in r* reduces investment, increasing net capital outflows and the supply of dollars in the foreign exchange market… …causing the real exchange rate to fall and NX to rise. ε NX NX(ε) 1 1 ( *) S I r  NX1 ε1 2 1 ( ) * S I r  ε2 NX2
  • 40. CHAPTER 5 The Open Economy slide 39 3. An increase in investment demand An increase in investment reduces net capital outflows and the supply of dollars in the foreign exchange market… ε NX NX(ε) …causing the real exchange rate to rise and NX to fall. ε1 1 1 S I  NX1 2 1 S I  NX2 ε2
  • 41. CHAPTER 5 The Open Economy slide 40 4. Trade policy to restrict imports ε NX NX(ε)1 S I  NX1 ε1 NX(ε)2 At any given value of ε, an import quota  IM  NX  demand for dollars shifts right Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remains fixed. ε2
  • 42. CHAPTER 5 The Open Economy slide 41 4. Trade policy to restrict imports ε NX NX(ε)1 S I  NX1 ε1 NX(ε)2 Results: ε > 0 (demand increase) NX = 0 (supply fixed) IM < 0 (policy) EX < 0 (rise in ε ) ε2
  • 43. CHAPTER 5 The Open Economy slide 42 The Determinants of the Nominal Exchange Rate  Start with the expression for the real exchange rate: * e P ε P    Solve it for the nominal exchange rate: * P e ε P  
  • 44. CHAPTER 5 The Open Economy slide 43 The Determinants of the Nominal Exchange Rate ( * , ) M L r Y P   ( ) ( ) * NX ε S I r    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: * P e ε P   * * * * ( * *, ) M L r Y P   
  • 45. CHAPTER 5 The Open Economy slide 44 The Determinants of the Nominal Exchange Rate  We can rewrite this equation in terms of growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ): * P e ε P   * * e ε P P e ε P P        * ε ε        For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates.
  • 46. CHAPTER 5 The Open Economy slide 45 Inflation and nominal exchange rates Percentage change in nominal exchange rate 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 Inflation differential Depreciation relative to U.S. dollar Appreciation relative to U.S. dollar -1 -2 -3 1 0 2 3 4 5 6 8 7 France Canada Sweden Australia UK Ireland Spain South Africa Italy New Zealand Netherlands Germany Japan Belgium Switzerland
  • 47. CHAPTER 5 The Open Economy slide 46 Purchasing Power Parity (PPP)  def1: a doctrine that states that goods must sell at the same (currency-adjusted) price in all countries.  def2: the nominal exchange rate adjusts to equalize the cost of a basket of goods across countries.  Reasoning: arbitrage, the law of one price
  • 48. CHAPTER 5 The Open Economy slide 47 Purchasing Power Parity (PPP)  PPP: e P = P* Cost of a basket of domestic goods, in foreign currency. Cost of a basket of domestic goods, in domestic currency. Cost of a basket of foreign goods, in foreign 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.
  • 49. CHAPTER 5 The Open Economy slide 48 Purchasing Power Parity (PPP)  If e = P*/P, then * * * 1 P P P ε e P P P      and the NX curve is horizontal: ε NX NX ε = 1 S  I Under PPP, changes in (S  I ) have no impact on ε or e.
  • 50. CHAPTER 5 The Open Economy slide 49 Does PPP hold in the real world? No, for two reasons: 1. International arbitrage not possible.  nontraded goods  transportation costs 2. Goods of different countries not perfect substitutes. Nonetheless, PPP is a useful theory: • It’s simple & intuitive • In the real world, nominal exchange rates have a tendency toward their PPP values over the long run.
  • 51. CHAPTER 5 The Open Economy slide 50 no change no change       no change no change         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 1980s 1970s 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
  • 52. CHAPTER 5 The Open Economy slide 51 The U.S. as a large open economy  So far, we’ve learned long-run models for two extreme cases:  closed economy (chapter 3)  small open economy (chapter 5)  A large open economy---like the U.S.---is in between these two extremes.  The analysis of policies or other exogenous changes in a large open economy is a mixture of the results for the closed & small open economy cases.  For example…
  • 53. CHAPTER 5 The Open Economy slide 52 NX I r large open economy small open economy closed economy A fiscal expansion in three models falls, but not as much as in small open economy falls no change falls, but not as much as in closed economy no change falls rises, but not as much as in closed economy no change rises A fiscal expansion causes national saving to fall. The effects of this depend on the degree of openness:
  • 54. CHAPTER 5 The Open Economy slide 53 Chapter 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
  • 55. CHAPTER 5 The Open Economy slide 54 Chapter 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.
  • 56. CHAPTER 5 The Open Economy slide 55 Chapter summary 6. 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 7. 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.
  • 57. CHAPTER 5 The Open Economy slide 56