CHAPTER FIVE The Open Economy

CHAPTER FIVE The Open Economy 1 Chapter Five Y = C + I + G + NX Total demand for domestic output is composed of Investment spending by businesse...
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CHAPTER FIVE

The Open Economy

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Chapter Five

Y = C + I + G + NX Total demand for domestic output

is composed of

Investment spending by businesses and households

Net exports or net foreign demand

Consumption Government spending by purchases of goods households and services Note: NX = EX-IM. Domestic spending on all goods and services =domestic spending on domestics goods and services + on foreign goods and services. C + G + I = Y - EX + IM Chapter Five

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What do Net Exports cover? Y+IM= C+G+I+EX The national income accounts identity can be re-written as:

NX = Y - (C + I + G) Net Exports

Output

Domestic Spending

Domestic spending need not equal the output of goods and services. If output (Y) > domestic spending (C+I+G): we export the difference: net exports are positive ( NX > 0 ). If output (Y) < domestic spending (C+I+G): we import the difference: net exports are negative ( NX < 0 ). 3

Chapter Five

Start with the national income accounts identity. Y=C+I+G+NX. National saving: Y- C - G = I + NX.

S: national saving, S = I + NX. Relationship of Savings and Investment: S – I = NX. An economy’s net exports must always equal the difference between its saving and its investment. S – I = NX Trade Balance Net Foreign Investment Net foreign investment: the part of national savings which is not invested at home, that is: net capital outflow Chapter Five

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Net Capital Outflow = Trade Balance

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. What happens with international flows of capital and goods? How does the trade balance respond to changes in policy? Model of a small open economy 5

Chapter Five

Real interest rate, r* r* rclosed r*'

S 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 (r*). • The difference between saving and investment determines the trade balance (NX). I(r)

NX Investment, Saving, I, S In this case, since r* is above rclosed and saving exceeds investment, there is a trade surplus. If the world interest rate decreased to r* ', I would exceed S and there would be a trade deficit.

Chapter Five

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• Trade balance = net capital outflow = saving - investment (NX = S - I) • our model focuses on saving and investment. • Now the real interest rates are defined in world financial markets, so they cannot equilibrate national saving and investment. • Instead: the economy can 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, r = r*. • In a closed economy: the interest rate is determined by the equilibrium of domestic saving and investment

• The world is like a closed economy, therefore the equilibrium of world saving and world investment determines the world interest rate. 7

Chapter Five

Y = Y = F(K,L)

C = C (Y-T) I = I (r) 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 the interest rate equals the world interest rate, r*. NX = (Y-C(Y-T) - G) - I (r*) NX = S - I (r*) The trade balance is determined by the difference between saving and investment at the world interest rate. Chapter Five

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An increase in government purchases or a cut in taxes decreases national saving and thus shifts the national saving schedule to the left. Real S' S interest NX = (Y-C(Y-T) - G) - I (r*) rate, r* NX = S - I (r*) The result is : a reduction in national saving which leads to a trade deficit, where I > S. I(r)

r* NX

Investment, Saving, I, S 9

Chapter Five

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 economy, causing a trade surplus where S > I.

r2* r1*

NX I(r) Investment, Saving, I, S

Chapter Five

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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 borrowing from abroad and running a trade deficit.

S

r1* NX

I(r)2 I(r)1

Investment, Saving, I, S 11

Chapter Five

The exchange rate between two countries is the price at which residents of those countries trade with each other.

• 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 Chapter Five

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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.

ε • The real exchange rate is the rate at which we can trade the goods of one country for the goods of another. • Example: An American car costs $10,000 ; a similar Japanese car costs 2,400,000 yen. • If 1dollar = 120 yen, then the American car costs 1,200,000 yen. • The American car costs one-half of what the Japanese car costs. • We can exchange 2 American cars for 1 Japanese car. 13

Chapter Five

ε The real exchange rate is the rate at which we can trade the goods of one country for the goods of another :

Real Exchange Rate =

(120 yen/dollar) × (10,000 dollars/American car) (2,400,000 yen/Japanese Car)

= 0.5 × Japanese Car / American Car More generally, 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 = e × (P/P*)

• If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are expensive. • If the real exchange rate is low, foreign goods are relatively expensive, and domestic goods are cheap.

P is the price level of the domestic country (measured in the domestic currency) P* is the price level of the foreign country (measured in the foreign currency). Chapter Five

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All changes in a nation’s price level will be fully incorporated into the nominal exchange rate. Purchasing Power Parity suggests that • nominal exchange rate movements primarily reflect differences in price levels of nations; 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. • 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 with a very flat net-exports schedule. 15

Chapter Five

S-I Real exchange rate, ε

The real exchange rate is determined by the intersection of • the vertical line representing saving minus investment • and downward-sloping net exports schedule.

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Chapter Five

• 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 NX(ε) supplied for net foreign investment equals the Net Exports, NX quantity of dollars demanded for the net exports of goods and services. 16

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Example (Book, p.143, Problem 2 • Consider an economy described by the following equations: • Y = C + I + G + NX, Y = 5000, G = 1000, T = 1000, • C = 250 + 0.75(Y − T), I = 1000 − 50r, NX = 500 − 500ε, r = r* = 5.

a. In this economy, solve for – national saving, – investment, – the trade balance, and – the equilibrium exchange rate. b. Suppose now that G rises to 1250. Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find. c. Now suppose that the world interest rate rises from 5 to 10 percent. (G is again 1000). Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find. 17

Chapter Five

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

Chapter Five

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