Chapter 5 - Open Economy PDF

ECONOMY IN THE LONG RUN
Chapter 5
The Open Economy

October 10, 2012
1
Chapter 5: The Open Economy. ECON204(A01) Fall 2012
In this Chapter, you will learn...
accounting identities of the open economy
The Small Open Economy Model
Exchange Rates
Large vs. Small Open Economy
Primary Indicators to Understand the Openness of an Economy
Figure 5.1 Imports and Exports as a Percentage of Output, 2007
1. THE INTERNATIONAL FLOWS OF CAPITAL AND GOODS
An Open Economy Differs from Closed Economy by

Spending need not equal output
Saving need not equal investment
Open economy measurement: net exports, balance of payments
and national accounting identities.
Domestic production (GDP) equals domestic expenditure
(absorption):
Where, CD , ID and GD indicate expenditure on domestic production
only that is, excluding expenditure on imports.
4
Total Consumption, Investment, and Government spending:
where F indicates spending on foreign goods, Then
The Standard Nation Income Identity

NX>0 or NX<0, that is domestic spending need not equal to domestic
production: NX Y
5
CIG
Trade Balance
NX = EX IM = Y (C + I + G )
Trade surplus:
output > spending and exports > imports
Size of the trade surplus = NX
Trade deficit:
spending > output and imports > exports
Size of the trade deficit = NX
Balanced trade: NX = 0
Now, Saving and Investment in an open economy: Capital Flows

Y = C + I + G + NX
Y C G = I + NX
S I = NX
The net domestic saving (S-I), is also referred as net foreign
investment or net capital outflow
Net Capital Outflow = Trade Balance
SI
NX
when S > I, country is a net lender

when S < I, country is a net borrower
The worlds largest debtor nation

Every year since 1980s: huge trade deficits and net capital inflows,
i.e. net borrowing from abroad
As of 12/31/2009:
U.S. residents owned $18.4 trillion worth of foreign assets
Foreigners owned $21.1 trillion worth of U.S. assets
U.S. net indebtedness to rest of the world:
$2.7 trillion--higher than any other country, hence U.S. is the
worlds largest debtor nation
Relationship between Savings, Investment, and Net Exports

Recall Gross National Product (GNP):
GNP = Y + NFI
Domestic production = domestic expenditure:
Y
C + I + G + NX
In terms of GNP:
GNP = Y + NFI = C + I + G + NX + NFI
Rewrite:
GNP C G I = NX + NFI
SI
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= NX + NFI
Balance of Payments
Consists of two components: (1) current account, and (2) capital
account.
1. Current Account:
CA = NX + Net Foreign Income
2. Capital Account:
KA = Net Capital Inflow: Private Sector +
Net Capital Inflow: Official
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Net Capital Inflow: Private Sector sale/purchase of assets

overseas by private agents.
o Capital inflow: sale of assets overseas (borrowing, raising
capital).
o Capital outflow: purchase of assets overseas
(lending/investing).
Example: purchase of equity in US company capital outflow
Net Capital Inflow: Official sale/purchase of assets overseas by
the central bank.
Example: central bank purchases US Dollar Bonds capital
outflow.
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By definition,
Balance of Payments = CA + KA = 0
Equivalently, since CA= S I
KA = (S I)
If S > I, we are lending overseas a capital outflow.
If I > S, we are borrowing from overseas a capital inflow.
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2. SMALL OPEN ECONOMY MODEL

Open economy version of the classical long run model of Chapter 3.
A small open economy is an economy smaller enough such that the
actions of the economy do not influence the world interest rate.
Economy is small - faces a given real world interest rate, r*.
Capital markets are perfect:
where,
is an (exogenous) risk premium. Assume this is zero for
the most part. So,
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Figure: Canadian and US Interest rates
15
The model:
Three assumptions:
I = I(r)
C = C(Y T)
The accounting identities:
Y = C + I + G + NX
Solving the model:
16
the exogenous
world interest
rate determines
investment
and the
difference
between saving
and investment
determines net
capital outflow
and net exports
S
NX
r*
rc
I (r )
I1
Figure: Saving and investment in a small open economy

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S, I
Policies affect the Trade Balance

Expansionary Fiscal Policy at Home
Figure: Impact of fiscal expansion at home economy
An increase in government spending (taxes constant) reduces

public saving (
). Reduces trade balance (
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Expansionary Fiscal Policy Abroad
If the foreign country is large enough fiscal expansion causes deficit and
pushes the world interest rate up.
Interest rate increases from r1* to r2* NX>0 , trade surplus
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Shift in Investment Demand
Due to incentives, invest demand is now I(r)2 saving unchanged

borrowing abroad to finance investment NX <0
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Evaluation of Economic Policy

Trade deficits or surpluses are not themselves (generally) a problem.
They may be a symptom of (important) underlying problems:
Too little domestic saving (either private or public) relative to
domestic investment, reducing the consumption of future
generations
Too much speculative and unproductive investment
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3. EXCHANGE RATES
The exchange rate between two countries is the price at which
residents of those countries trade with each other.
a) Nominal and Real Exchange Rates
The nominal exchange rate is the relative price of domestic currency
in terms of foreign currency, usually denoted by e.
For example, e(CAD/USD) is the Canadian dollar price of US dollar.
That is, how many CAD you can buy by one US dollar (i.e., 0.99
CAD$/US$).
So, what is the price of Canadian dollar?
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The real exchange rate, , the relative price of domestic goods

in terms of foreign goods (e.g. Japanese Big Macs per Canadian Big
Mac).
The real exchange rate is sometimes called the terms of trade.
Real Exchange rate,
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~ McZample ~
One good: Big Mac
price in Japan: P* = 200 Yen
price in Canada: P = $3.00
nominal exchange rate, e = 90 Yen/CAN$
What is ?
To buy a Canadian Big Mac, someone from Japan would have to

pay an amount that could buy 1.35 Japanese Big Macs.
Ans.: CAN$ 1.35
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Change in nominal exchange rate: e(USD/CAD)

e rising is an appreciation of the CAD
e falling is a depreciation of the CAD
Different types of exchange rate regimes
Floating exchange rate e is determined in the foreign
exchange market with little or no intervention by central banks;
Managed exchange rate e is managed by central banks
according to some rule;
Fixed exchange rate central bank(s) set a price and enter the
market to support the price as required;
Currency Board/Common currency - strong types of fixed
exchange rates
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in the real world & our model

In the real world: We can think of as the relative price of a basket
of domestic goods in terms of a basket of foreign goods
In our macro model: Theres just one good, output. So, is the
relative price of one countrys output in terms of the other
countrys output
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b) Trade Balance and the Real Exchange Rate

If real exchange rate rises (an appreciation), then domestic goods are
relatively expensive and there is switching away from domestic to
foreign goods - NX falls.
Canadian goods become more expensive relative to foreign
goods
EX, IM
NX
If real exchange rate falls (a depreciation), then domestic goods are

relatively cheap and there is switching away from foreign to
domestic goods - NX rises.
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The net exports function reflects this inverse relationship between NX

and : NX = NX( )
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The NX curve for Canada

When is relatively low, Canadian goods are relatively
inexpensive
Canadian net exports will be high
29
At higher values of , Canadian goods become so expensive that

Canada exports less than import
30
c) How is determined?
The accounting identity says NX = S I
We saw earlier how S I is determined:
S depends on domestic factors (Y, fiscal policy variables, etc)
I is determined by the world interest rate r *
So, must adjust to ensure
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Neither S nor I depend on , so the net capital outflow curve is

vertical.
adjusts to equate NX with net capital outflow, S - I.
S1 I(r*)
NX()
32
NX1
NX
Effects of Policies on the Real Exchange Rate

1. Fiscal policy at home
A fiscal expansion reduces national saving, net capital outflow,
and the supply of dollars in the foreign exchange market
causing the real

exchange rate to rise
and NX to fall
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2. Fiscal policy abroad

An increase in r* reduces investment, increasing net capital outflow
and the supply of dollars in the foreign exchange market
causing the real

exchange rate to fall
and NX to rise.
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3. An increase in investment demand

An increase in investment reduces net capital outflow and the
supply of dollars in the foreign exchange market
causing the
real exchange
rate to rise
and NX to fall.
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4. Trade policy to restrict imports

At any given value of , an import quota
demand for dollars shifts right
Trade policy doesnt affect S or I , so capital flows and the supply of
dollars remain fixed.
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d) How e is determined?
The real exchange rate:
Solve for the nominal exchange rate:
38
Taking log and doing first order derivative, the nominal exchange
rate equation implies:
For a given value of , the growth rate of e equals the difference

between foreign and domestic inflation rates.
Alternatively,
The nominal exchange rate over the long-run is determined by the
relative rate of inflation between two countries.
39
Inflation differentials and nominal exchange rates: empirical evidence
40
e) Purchasing Power Parity
A doctrine that states that goods must sell at the same (currencyadjusted) price in all countries.
The purchasing power of one dollar is the same in every
country.
In Canada, 1CAD buys 1/P bundle of goods;
In US, 1 CAD buys e USD which buys 1/P* bundle of goods;
If the purchasing power is the same, then:
or,
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5. LARGE VERSUS SMALL OPEN ECONOMY

So far, weve 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 between these two
extremes.
The results from large open economy analysis are a mixture of the
results for the closed & small open economy cases.
For example
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46
Chapter Summary
Net exports--the difference between
exports and imports
a countrys output (Y ) and its spending (C + I + G)
Net capital outflow equals
purchases of foreign assets minus foreign purchases of the
countrys assets
the difference between saving and investment
National income accounts identities:
Y = C + I + G + NX
trade balance NX = S - I net capital outflow
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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.
Exchange rates
nominal: the price of a countrys currency in terms of another
countrys currency
real: the price of a countrys goods in terms of another
countrys goods
The real exchange rate equals the nominal rate times the ratio
of prices of the two countries.
How the real exchange rate is determined
NX depends negatively on the real exchange rate, ceteris paribus
The adjusts to equate NX with net capital outflow
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ECONOMY IN THE LONG RUN

The Open Economy

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

In this Chapter, you will learn...

accounting identities of the open economy

The Small Open Economy Model

Large vs. Small Open Economy

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Primary Indicators to Understand the Openness of an Economy

Figure 5.1 Imports and Exports as a Percentage of Output, 2007

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

1. THE INTERNATIONAL FLOWS OF CAPITAL AND GOODS

An Open Economy Differs from Closed Economy by

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Total Consumption, Investment, and Government spending:

where F indicates spending on foreign goods, Then

The Standard Nation Income Identity

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Now, Saving and Investment in an open economy: Capital Flows

when S > I, country is a net lender

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

The worlds largest debtor nation

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Relationship between Savings, Investment, and Net Exports

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Net Capital Inflow: Private Sector sale/purchase of assets

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

2. SMALL OPEN ECONOMY MODEL

is an (exogenous) risk premium. Assume this is zero for

the most part. So,

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Figure: Canadian and US Interest rates

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Solving the model:

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Figure: Saving and investment in a small open economy

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Policies affect the Trade Balance

Figure: Impact of fiscal expansion at home economy

An increase in government spending (taxes constant) reduces

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Expansionary Fiscal Policy Abroad

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Shift in Investment Demand

Due to incentives, invest demand is now I(r)2 saving unchanged

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Evaluation of Economic Policy

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

The real exchange rate, , the relative price of domestic goods

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

To buy a Canadian Big Mac, someone from Japan would have to

Chapter 5: The Open Economy. ECON204(A01) Fall 2012

Change in nominal exchange rate: e(USD/CAD)

Chapter 5: The Open Economy. ECON204(A01) Fall 2012