Macroeconomics

N. Gregory Mankiw

The Open
Economy

Presentation Slides

© 2019 Worth Publishers, all rights reserved

 IN THIS CHAPTER, YOU WILL LEARN:

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 and exchange
rate

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Imports and exports of selected countries, 2013
In an open economy,

• spending need not equal output

• saving need not equal investment
The national income identity in an open economy
Trade surpluses and deficits

NX = X – IM = Y – (C + I + G)

• Trade surplus:
output > spending and exports (X) > imports (IM)
Size of the trade surplus = NX
• Trade deficit:
spending > output and imports > exports
Size of the trade deficit = –NX
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 net lender
• When S < I, country is a net borrower
The link between trade and capital flows

NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
=S–I
trade balance = net capital outflow

Thus,
a country with a trade deficit (NX < 0)

is a net borrower (S < I ).

 Saving,
investment, and
the trade balance
1960–2014
U.S.: the world’s largest debtor nation

• Every year since the 1980s: huge trade deficits and net
capital inflows (that is, net borrowing from abroad)
• As of December 31, 2014:
• U.S. residents owned $24.7 trillion worth of foreign
assets
• Foreigners owned $31.6 trillion worth of U.S. assets
• U.S. net indebtedness to the rest of the world:
$6.9 trillion—higher than any other country, hence
U.S. is the “world’s largest debtor nation”
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
National saving: The supply of loanable funds

S = Y  C(Y  Y )  G

As in Chapter 3,
national saving does
not depend on the
interest rate
Assumptions about capital flows

a. Domestic and 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 and b imply r = r*
c implies r* is exogenous
Investment: The demand for loanable funds

Investment is still a
downward-sloping function
of the interest rate,

but the exogenous

world interest rate…
…determines the
country’s level of
investment.
 If the economy were closed…

. . . the interest
rate would
adjust to
equate
investment
and saving.
 But in a small open economy…

the exogenous
world interest rate
determines
investment…

…and the
difference
between saving
and investment
determines net
capital outflow
and net exports
Three experiments:

1. Fiscal policy at home

2. Fiscal policy abroad
3. An increase in investment demand (exercise)
 1. Fiscal policy at home (1 of 2)

An increase in G
or decrease in T
reduces saving.

Results:
ΔI = 0
ΔNX = ΔS < 0
NX and the federal budget deficit (% of GDP), 1965–2014
 2. Fiscal policy abroad

Expansionary
fiscal policy
abroad raises
the world
interest rate.

Results:
ΔI < 0
ΔNX =  ΔI > 0
NOW YOU TRY
3. An increase in investment demand

Use the
model to
determine
the impact of
an increase
in investment
demand on
NX, S, I, and

net capital
outflow.
NOW YOU TRY
3. An increase in investment demand, answers

ΔI > 0,
ΔS = 0,
net capital
outflow
and NX
fall by the
amount
ΔI
The nominal exchange rate

e = nominal exchange rate, the relative price of domestic

currency in terms of foreign currency
(example: yen per dollar)
The real exchange rate

= real exchange rate, the relative price

of domestic goods in terms of foreign
goods
(example: Japanese Big Macs per
U.S. Big Mac)
Understanding the units of ε

e×P
ε=
P*

=
 Yen per $   $ per unit U.S. goods 
Yen per unit Japanese goods
Yen per unit U.S. goods
=
Yen per unit Japanese goods
Units of Japanese goods
=
per unit of U.S. goods
~ McZample ~

• One good: Big Mac

e ×P
• Price in Japan: ε=
P* = 200 yen P*
• Price in the U.S.: 120 × $2.50
= = 1.5
P = $2.50 200 Yen
• Nominal exchange rate
e = 120 yen/$
To buy a U.S. Big Mac,
someone from Japan
would have to pay an
amount that could buy
1.5 Japanese Big Macs.
ε in the real world and 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.
How NX depends on ε

If ε rises:
• U.S. goods become more expensive relative to foreign
goods
• exports fall, imports rise
• net exports fall
U.S. net exports and the real exchange rate, 1973–2015
The net exports function

The net exports function reflects this inverse relationship

between NX and ε :
NX = NX(ε )
 The NX curve for the United States, part 1

. . .so U.S. net

exports will be
high.
When ε is
relatively low,
U.S. goods are
relatively
inexpensive . . .
The NX curve for the United States, part 2

At high enough values

of ε, U.S. goods
become so expensive
that we export less
than we import.
How ε is determined (1 of 2)

• 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 *)
 How ε is determined (2 of 2)

Neither S nor I
depends on ε, so
the net capital
outflow curve is
vertical.

ε adjusts to
equate NX
with net capital
outflow, S − I.
 Interpretation: Supply and demand in the foreign exchange
market

Demand:
Foreigners need
dollars to buy U.S.
net exports.

Supply:
Net capital
outflow (S - I )
is the supply of
dollars to be
invested abroad.
Four experiments

1. Fiscal policy at home

2. Fiscal policy abroad
3. An increase in investment demand (exercise)
4. Trade policy to restrict imports
 1. Fiscal policy at home (2 of 2)

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.
 1. 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.
NOW YOU TRY
3. Increase in investment demand

Determine the
impact of an
increase in
investment
demand on net
exports, net
capital outflow,
and the real
exchange rate.
NOW YOU TRY
3. Increase in investment demand, answers
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.
 4. Trade policy to restrict imports, part 1

At any given ε, an
import quota
reduces IM,
increases NX, and
increases demand
for dollars.

Trade policy doesn’t

affect S or I , so
capital flows and
the supply of dollars
remain fixed.
 4. Trade policy to restrict imports, part 2

Results:
Δε > 0
(demand increase)
ΔNX = 0
(supply fixed)
ΔIM < 0
(policy)
ΔEX < 0
(rise in ε )
The determinants of the nominal exchange rate, part 1

• Start with the expression for the real exchange rate:

e×P
ε= *
P
• Solve for the nominal exchange rate:

P*
e =ε ×
P
The determinants of the nominal exchange rate, part 2

• 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:
The determinants of the nominal exchange rate, part 3

P*
e=ε×
P

Rewrite this equation in growth rates (see “Two Helpful

Hints for Working with Percentage Changes” in Chapter 2):

Δe Δε Δ P * Δ P Δε
= + *  = + π*  π
e ε P P ε

For a given value of ε, the growth rate of e equals the

difference between foreign and domestic inflation rates.
Inflation differentials and nominal exchange rates for a cross
section of countries
Purchasing-power parity (PPP), part 1

Two definitions:
• a doctrine that states that goods must sell at the same
(currency-adjusted) price in all countries
• the nominal exchange rate adjusts to equalize the cost
of a basket of goods across countries
Reasoning:
arbitrage, the law of one price
Purchasing-power parity (PPP), part 2

 Solve for e: e = P*/ P

 PPP implies that the nominal exchange rate between two
countries equals the ratio of the countries’ price levels.
 Purchasing-power parity (PPP), part 3

If e = P * / P ,
P P* P
then ε = e × * = × * =1
P P P
and the NX curve is horizontal :

Under PPP, changes

in (S – I ) have no
impact on ε or e.
Does PPP hold in the real world?

No, for two reasons:

1. International arbitrage is not possible
• nontraded goods
• transportation costs
2. Different countries’ goods are not perfect substitutes
Yet PPP is a useful theory:
• It’s simple and intuitive.
• In the real world, nominal exchange rates tend toward
their PPP values over the long run.
 CASE STUDY: The Reagan Deficits Revisited

1970s 1980s Actual Closed Small open

change economy economy
G-T 2.2 3.9   
S 19.6 17.4   
r 1.1 6.3   no change

I 19.9 19.4   no change

NX -0.3 -2.0  no 
change
ε 115.1 129.4  no 
change

Data: Decade averages; all except r and ε are expressed as

a percentage of GDP; ε is a trade-weighted index.
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.—falls between
these two extremes.
• The results from large open-economy analysis are a
mixture of the results for the closed and small open-
economy cases.
• For example . . .
 A fiscal expansion in three models

A fiscal expansion causes national saving to fall.

The effects of this depend on openness and size.
Closed Large open Small open
economy economy economy
r rises rises, but not as no change
much as in a closed
economy
I falls falls, but not as no change
much in a closed
economy
NX no change falls, but not as falls
much as in an open
economy
 CHAPTER SUMMARY, PART 1
• 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

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 CHAPTER SUMMARY, PART 2
• National income accounts identities
• Y = C + I + G + NX
• trade balance NX = S – I net capital outflow
• 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)

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 CHAPTER SUMMARY, PART 3
• 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.

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 CHAPTER SUMMARY, PART 4
• 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

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 CHAPTER SUMMARY, PART 5
• 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 and domestic inflation
rates.

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