### Chapter 5

```CHAPTER 5
The Open Economy
A PowerPointTutorial
To Accompany
MACROECONOMICS, 7th. Edition
N. Gregory Mankiw
Tutorial written by:
Mannig J. Simidian
B.A. in Economics with Distinction, Duke University
1
M.P.A., Harvard University Kennedy School of Government
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
Chapter Five
®
When an economy is so-called, “open,” it means that a country’s
spending in any given year is not equal to its output of goods and
services. A country can spend more that it produces by borrowing
from abroad, or it can spend less and lend the difference to foreigners.
Let’s turn to national income accounting to explain.
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2
Y = C + I + G + NX
Total demand
for domestic
output
is composed
of
Investment
spending by
households
Net exports
or net foreign
demand
Consumption
Government
spending by purchases of goods
households
and services
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 and3
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services.
Y = C + I + G + NX
After some manipulation, the national income accounts identity can be
re-written as:
NX = Y - (C + I + G)
Net Exports
Output
Domestic
Spending
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.
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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
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Net Foreign Investment
5
Net Capital Outflow =
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. Simply put, if Saving > Investment then
Net Capital Outflow > 0.
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. Simply put, if Saving < Investment then
Net Capital Outflow < 0.
If S - I and NX are exactly zero, we have balanced trade since the value
of imports equals the value of exports. Simply put, if Saving = Investment
then Net Capital Outflow = 0.
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6
A bilateral trade balance between two countries means that the
value of what a country sells to one country is equal to the value of
what it buys from that country. For example, there would be a
bilateral trade balance between the United States. and China if the
United States buys a pair of shoes from China valued at \$300, but also
sells a pair of jeans to China for \$300.
A nation can have large trade deficits and surpluses with different
countries but have balanced trade overall. For example, there would
be balanced trade overall if the United States sells a \$300 pair of jeans to
Japan, Japan sells a \$300 car seat to China, and China sells a \$300 pair of
shoes to the United States. In this case, each country that bought
something without having sold something to the country it bought the
good from has a bilateral trade deficit. But, each nation has balanced trade
overall, exporting and importing \$300 worth of goods.
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7
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.
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8
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
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.
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The economy’s output Y is fixed by the
factors of production and the production
function.
Consumption is positively related to
C = C (Y-T)
disposable income (Y - T).
Investment is negatively related to the
I = I (r)
real interest rate.
The national income accounts identity,
NX = (Y-C-G) - I
expressed in terms of saving and investment.
or NX = S - I
Now substitute our three assumptions from Chapter 3 and the assumption
that the interest rate equals the world interest rate, r*.
Y = Y = F(K, L)
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.
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Suppose the economy begins in a position of balanced trade. In
other words, at the world interest rate, investment I equals savings S,
and net exports equal zero. Let’s use our model to predict the
effects of government policies at home or abroad.
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11
Real
interest
rate, r*
S
In a closed economy, r adjusts to
equilibrate saving and investment.
In a small open economy, the
NX
interest rate is set by world
r*
financial markets. The difference
between saving and investment
rclosed
In this case, since r* is
r*'
Above rclosed and saving
I(r)
NX
exceeds investment,
Investment, Saving, I, S
Hence, starting from balanced trade, an increase
If the world interest rate decreased to r* ', I would exceed S and
surplus.
12
Five
thereChapter
would
An increase in government purchases or a cut in taxes decreases
national saving and thus shifts the national saving schedule to the left.
Real
interest
rate, r*
S'
S
NX = (Y - C(Y - T) - G) - I (r*)
NX = S
- I (r*)
The result is a reduction in national
where I > S.
r*
NX
I(r)
Investment, Saving, I, S
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A fiscal expansion in a foreign economy large enough to influence
world saving and investment raises the world interest rate
from r1* to r2*.
Real
interest
rate, r*
S
The higher world interest rate reduces
investment in this small open
where S > I.
r2 *
r1 *
NX
I(r)
Investment, Saving, I, S
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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*.
Real
interest
rate, r*
As a result, investment now
exceeds saving I > S, which
means the economy is
S
r1 *
I(r)2
NX
I(r)1
Investment, Saving, I, S
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A Mankiw
Macroeconomics
Case Study
During the 1980s, 1990s, and 2000s, the U.S. ran large trade deficits, with the exact size
fluctuating over time yet still quite large. In 2007, the trade deficit was \$708 billion or 5.1%
of GDP. As accounting identities require, this trade deficit had to be financed by borrowing
from abroad (i.e. selling U.S. assets abroad). During this period the U.S. went from being
the world’s largest creditor to the largest debtor.
What caused the U.S. trade deficit? There is no single explanation. But to understand some
of the forces at work, look at national saving and domestic investment (remember that the
trade deficit is the difference between saving and investment).
The start of the trade deficit coincided with a fall in national saving. This development can
be explained by the expansionary fiscal policy in the 1980s. With the support of President
Reagan, the U.S. Congress passed legislation in 1981 that substantially cut personal income
taxes over the next three years. Because these tax cuts were not met with equal cuts in
government spending, the federal budget went into deficit. These budget deficits were the
largest ever experienced in a period of peace and prosperity, and they continued long after
Reagan left office. According to our model, such a policy would reduce national saving,
causing a trade deficit. Because the government budget and the trade balance went into
deficit at the same time, these shortfalls were called the TWIN DEFICITS. Lets see what
happens as things start to change in the 90s on the next slide…
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A Mankiw
Macroeconomics
Case Study
More on the U.S. Trade Deficit
Things started to change in the 1990s, when the U.S. federal government got its fiscal
house in order. The first President Bush and President Clinton both signed tax increases,
while Congress put a lid on spending. In addition to these policy changes, rapid productivity
growth in the late 1990s raising incomes and thus further increased tax revenue. These
developments moved the U.S. federal budget to surplus, which in turn caused national
savings to rise.
In contrast to what our model predicts, the increase in national saving did not coincide
with a shrinking trade deficit, because domestic investment rose at the same time. The
likely explanation is that the boom in information technology caused an expansionary
shift in the U.S. investment function. Even though fiscal policy was pushing the trade
deficit toward surplus, the investment boom was an even stronger force pushing the trade
balance toward deficit.
In the early 2000s, fiscal policy once again put downward pressure on national saving.
With the second President Bush, tax cuts were signed into law in 2001 and 2003, while
the war on terror led to substantial increases in government spending. The federal
government was again running budget deficits. National saving fell into historic lows, and
the trade deficit reached historic highs.
A few years later, the trade deficit started to shrink, as the economy experienced a
substantial decline in housing prices (see Chapters 11 and 18). Lower house prices
reduced housing investment. They also made households poorer, inducing them to reduce
consumption and increase saving. The trade deficit fell from .1% of GDP as its peak in the
fourth quarter of 2005 to 4.9% in the third quarter of 2007.
The history of the U.S. trade deficit shows that this statistic, by itself, does not tell us much
about what is happening in the economy. We have to look deeper at saving, investment,
and the policies and events that cause them (and thus the trade balance) to change over time.
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In the next few slides, we’ll learn about the foreign
exchange market, exchange rates and much more!
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Let’s think about when the United States and Japan engage in trade. Each
country has different cultures, languages, and currencies, all of which
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 United States 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 United States into the demand for yen, and conversely, the
supply of yen into the demand for dollars.
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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.
DemandYEN
SupplyYEN
Supply\$
Foreign
Exchange
Market
Demand\$
In order for Japan to pay for its imports of
goods and services and securities from the
it must
supply yen which are then converted
U.S.,Chapter
Five
into dollars by the foreign exchange market.
20
The exchange rate between two countries is the price at which
residents of those countries trade with each other. Economists
distinguish between two exchange rates: the nominal exchange rate
and the real exchange rate.
The nominal exchange rate is the relative price of the currency of two
countries.
The real exchange rate is the relative price of the goods of two
countries.
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-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 e
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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 a 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.
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Suppose that there is an increase in the demand for U.S. goods and
services. How will this affect the nominal exchange rate?
S\$
e
e1
e0
A
B
D\$
\$
Dollar Value of Transactions
Chapter Five
D\$ shifts rightward and increases
the nominal exchange rate, e.
This is known as appreciation
of the dollar.
Events which decrease the
demand for the dollar, and thus
\$
D  decrease e, would be a
depreciation of the dollar.
24
e
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 two
American cars for one Japanese car.
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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
26
Chapter Five
the currencies
are exchanged.
Real Exchange
Rate
Nominal
Exchange
Rate
Ratio of Price
Levels
e = e × (P/P*)
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).
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Real Exchange
Rate
Nominal Exchange
Rate
Ratio of Price
Levels
e = 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.
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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
parity does not always hold because some goods are not easily
substitutes—but it does give us reason to expect that fluctuations in
the real exchange rate will be small and temporary.
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Real
exchange
rate, e
S-I
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.
NX(e)
Net Exports, NX
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Real
exchange
rate, e
The relationship between the real exchange rate
and net exports is negative: the lower the real
S-I exchange rate, the less expensive are domestic
goods relative to foreign goods, and thus the
greater are our net exports.
The real exchange rate is determined by the
intersection of the vertical line representing
saving minus investment and downward-sloping
net exports schedule.
0
Chapter Five
Here the quantity of dollars
NX(e) supplied for net foreign
investment equals the
Net Exports, NX
quantity of dollars demanded
for the net exports of goods
31
and services.
Real
exchange
rate, e
e2
e1
S2 - I S1- IExpansionary fiscal policy at home, such as an
increase in government purchases G or a cut in
taxes, reduces national saving.
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 e1 to e2.
NX(e)
NX2
Chapter Five
A reduction in saving reduces
NX1 Net Exports, NX the supply of dollars, which
causes the real exchange rate
to rise and causes net exports
to fall.
32
Real
exchange
rate, e
S - I(r1*)S - I (r2*) Expansionary fiscal policy abroad reduces
world saving and raises the world interest
rate from r1* to r2*.
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.
e1
e2
NX(e)
NX1
Chapter Five
NX2 Net Exports, NX
As a result, the equilibrium
real exchange rate falls
from e1 to e2.
33
Real
exchange
rate, e
S - I2
An increase in investment demand raises
the quantity of domestic investment from I1
to I2.
As a result, the supply of dollars to be
exchanged into foreign currencies falls
from S - I1 to S - I2.
This fall in supply raises the
equilibrium real exchange
NX(e) rate from e1 to e2.
e2
e1
NX2
Chapter Five
S - I1
NX1 Net Exports, NX
34
Net exports
Net capital outflow