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19 the open economy
1. Chapter Five 1
A PowerPoint™Tutorial
to Accompany macroeconomics, 5th ed.
N. Gregory Mankiw
®
The Open Economy
2. Chapter Five 2
Government
purchases of goods
and services
Government
purchases of goods
and services
Y = C + I + G + NXY = C + I + G + NX
Total demand
for domestic
output
Total demand
for domestic
output
Consumption
spending by
households
Consumption
spending by
households
Investment
spending by
businesses and
households
Investment
spending by
businesses and
households
Net exports
or net foreign
demand
Net exports
or net foreign
demand
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.
is composed
of
is composed
of
3. Chapter Five 3
Y = C + I + G + NXY = C + I + G + NX
After some manipulation, the national income accounts identity can be
re-written as:
NX = Y - (C + I + G)NX = Y - (C + I + G)
Net ExportsNet Exports OutputOutput
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.
Domestic
Spending
Domestic
Spending
4. Chapter Five 4
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. Chapter Five 5
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.
Net Capital
Outflow = Trade
Balance
9. Chapter Five 9
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.
10. Chapter Five 10
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.
11. Chapter Five 11
C = C (Y-T)
I = I (r)
Y = Y = F(K,L)
NX = (Y-C-G) - I
or NX = S - I
The economy’s output Y is fixed by the
factors of production and the production
function.
Consumption is positively related to
disposable income (Y-T).
Investment is negatively related to the
real interest rate.
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.
12. Chapter Five 12
S
I(r)
Investment, Saving, I, S
Real
interest
rate, r*
rclosed
r*
NX
In a closed economy, r adjusts to
equilibrate saving and investment.
In a small open economy, the
interest rate is set by world
financial markets. The difference
between saving and investment
determines the trade balance.
In this case, since r* is above rclosed and saving exceeds investment,
there is a trade surplus.
r*'
NX
If the world interest rate decreased to r* ', I would exceed S and
there would be a trade deficit.
13. Chapter Five 13
S
I(r)
Investment, Saving, I, S
Real
interest
rate, r*
r*
S'
An increase in government purchases or a cut in taxes decreases
national saving and thus shifts the national saving schedule to the left.
NX
The result is a reduction in national
saving which leads to a trade deficit,
where I > S.
NX = (Y-C(Y-T) - G) - I (r*)
NX = S - I (r*)
14. Chapter Five 14
S
I(r)
Investment, Saving, I, S
Real
interest
rate, r*
r1*
A fiscal expansion in a foreign economy large enough to influence
world saving and investment raises the world interest rate
from r1* to r2*.
NX
The higher world interest rate reduces
investment in this small open
economy, causing a trade surplus
where S > I.
r2*
15. Chapter Five 15
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
16. Chapter Five 16
In the next few slides, we’ll learn about the foreign
exchange market, exchange rates and much more!
17. Chapter Five 17
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.
18. Chapter Five 18
it must supply yen which are then converted
into dollars by the foreign exchange market.
Foreign
Exchange
Market
Foreign
Exchange
Market
Supply$
DemandYEN
Demand$SupplyYEN
In order for Japan to pay for its imports of
goods and services and securities from the
U.S.,
In order for the U.S to pay for its imports of
goods and services and securities from Japan,
it must supply dollars which are then converted
into yen by the
foreign
exchange
market.
&
Securities
GOODS & SERVICES
GOODS & SERVICES
Goods and Services
& SECURITIES
SECURITIES
19. Chapter Five 19
The exchange rate between two countries is the price at which
residents of those countries trade with each other.
20. Chapter Five 20
-relative price of the currency of two countries
-denoted as e
-relative price of the currency of two countries
-denoted as e
-relative price of the goods of two countries
-sometimes called the terms of trade
-denoted as ε
-relative price of the goods of two countries
-sometimes called the terms of trade
-denoted as ε
21. Chapter Five 21
The nominal exchange rate is the relative price of the currency of
two countries. For example, if the exchange rate between the U.S.
dollar and the Japanese yen is 120 yen per dollar, then you can
exchange 1 dollar for 120 yen in world markets for foreign currency.
A Japanese who wants to obtain dollars would pay 120 yen for each
dollar he bought. An American who wants to obtain yen would get
120 yen for each dollar he paid. When people refer to “the exchange
rate” between two countries, they usually mean the nominal exchange
rate.
The nominal exchange rate is the relative price of the currency of
two countries. For example, if the exchange rate between the U.S.
dollar and the Japanese yen is 120 yen per dollar, then you can
exchange 1 dollar for 120 yen in world markets for foreign currency.
A Japanese who wants to obtain dollars would pay 120 yen for each
dollar he bought. An American who wants to obtain yen would get
120 yen for each dollar he paid. When people refer to “the exchange
rate” between two countries, they usually mean the nominal exchange
rate.
22. Chapter Five 22
D$
shifts rightward and increases
the nominal exchange rate, e.
This is known as appreciation
of the dollar.
Be1
e
Dollar Value of Transactions
D$
Ae0
S$
$
Suppose that there is an increase in the demand for U.S. goods and
services. How will this affect the nominal exchange rate?
Events which decrease the
demand for the dollar, and thus
decrease e would be a
depreciation of the dollar.
D$
′
23. Chapter Five 23
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.
ε
24. Chapter Five 24
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.
ε
25. Chapter Five 25
ε = e × (P/P*)
Real Exchange
Rate
Nominal
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).
26. Chapter Five 26
ε = e × (P/P*)
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.
Real Exchange
Rate
Nominal Exchange
Rate
Ratio of Price
Levels
28. Chapter Five 28
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.
29. Chapter Five 29
NX(ε)
Net Exports, NX
Real
exchange
rate, ε
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.
S-I
30. Chapter Five 30
NX(ε)
Net Exports, NX
Real
exchange
rate, ε
0
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
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.
Here the quantity of dollars
supplied for net foreign
investment equals the
quantity of dollars demanded
for the net exports of goods
and services.
31. Chapter Five 31
NX(ε)
Net Exports, NX
Real
exchange
rate, ε
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 ε1 to ε2.
S1-I Expansionary fiscal policy at home, such as an
increase in government purchases G or a cut in
taxes, reduces national saving.
A reduction in saving reduces
the supply of dollars which
causes the real exchange rate
to rise and causes net exports
to fall.
S2-I
NX2
ε2
ε1
32. Chapter Five 32
NX(ε)
Net Exports, NX
Real
exchange
rate, ε
NX2
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*.
As a result, the equilibrium
real exchange rate falls from
ε1 to ε2.
NX1
ε1
ε2
S-I(r1*)
33. Chapter Five 33
NX(ε)
Net Exports, NX
Real
exchange
rate, ε
NX1
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.
This fall in supply raises the
equilibrium real exchange
rate from ε1 to ε2.
NX2
ε1
ε2
S-I2
34. Chapter Five 34
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
