This chapter discusses key concepts in open economy macroeconomics including imports, exports, the trade balance, exchange rates, and how fiscal and monetary policies can impact these variables. It introduces accounting identities that relate gross domestic product (GDP), consumption (C), investment (I), government spending (G), net exports (NX), and net capital outflows. It also presents models of a small open economy and how exchange rates adjust to equate the trade balance with capital flows.

1. CHAPTER FIVE The Open Economy

3. Imports and Exports as a percentage of output: 2000 Percentage of GDP 40 35 30 25 20 15 10 5 0 Canada France Germany Italy Japan U.K. U.S. Imports Exports

7. GDP = expenditure on domestically produced g & s

12. National Saving: The Supply of Loanable Funds As in Chapter 3, national saving does not depend on the interest rate r S, I

14. 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. If the economy were closed… … the interest rate would adjust to equate investment and saving: r S, I I ( r ) r c

16. But in a small open economy… the exogenous world interest rate determines investment… … and the difference between saving and investment determines net capital outflows and net exports NX r S, I I ( r ) r c r* I 1

18. 1. Fiscal policy at home An increase in G or decrease in T reduces saving. r S, I I ( r ) I 1 NX 1 NX 2 Results:

19. NX and the Government Budget Deficit Budget deficit (right scale) Net exports (left scale)

20. 2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. Results: r S, I I ( r ) NX 1 NX 2

21. 3. An increase in investment demand EXERCISE: Use the model to determine the impact of an increase in investment demand on NX , S , I , and net capital outflow. r S, I I ( r ) 1 NX 1 I 1 S

22. 3. An increase in investment demand ANSWERS :  I > 0,  S = 0, net capital outflows and net exports fall by the amount  I r S, I I ( r ) 1 NX 2 NX 1 I 1 I 2 S I ( r ) 2

24. Exchange rates as of June 6, 2002 9.7 Pesos/$ Mexico 1,444,063.1 Liras/$ Turkey 0.68 Pounds/$ U.K. 31.4 Rubles/$ Russia 1.06 Euro/$ Euro exchange rate country 9.8 Rand/$ South Africa 124.3 Yen/$ Japan

26. Understanding the units of ε ε

30. U.S. Net Exports and the Real Exchange Rate, 1975-2002

32. The NX curve for the U.S. 0 NX ε NX ( ε ) ε 1 When ε is relatively low, U.S. goods are relatively inexpensive NX ( ε 1 ) so U.S. net exports will be high

33. The NX curve for the U.S. 0 NX ε NX ( ε ) ε 2 At high enough values of ε , U.S. goods become so expensive that NX ( ε 2 ) we export less than we import

42. 4. Trade policy to restrict imports Results:  ε  > 0 (demand increase)  NX = 0 (supply fixed)  IM < 0 (policy)  EX < 0 (rise in ε ) ε NX NX ( ε ) 1 NX 1 ε 1 NX ( ε ) 2 ε 2

46. 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

51. CASE STUDY The Reagan Deficits revisited Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index. 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

53. 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: NX I r large open economy small open economy closed economy