Intermediate macroeconomics chapt05

Chapter 5:
The Open Economy


International Trade
A country’s participation is measured by the value of
its

– export as a percentage of GDP
– Import as a percentage of GDP
Data indicate that while international trade is important
in the U.S., it is even more vital for other countries
such as Canada and France.


International Trade


National Income Accounting
The GDP for an open economy:
Y = C + I + G + NX

Consumption = C
Investment = I
Government purchases = G
Net Exports = NX (Exports less Imports)


National Income Identity
Y = C + I + G + NX
Y – C – G = I + NX

S = I + NX
Where S = Y - C - G is National Savings


Saving Investment Identity
Equilibrium in the product market:
S – I(r) = NX
Net Foreign Investment = Trade Balance
If S>I: foreign capital outflow; hence NX>0: trade surplus
If S

Twin Deficits
The federal budget deficit (G>T), reduces national
savings (S = Y – C – G)
Reduced national savings foreign capital inflow,
hence causing a trade deficit (NX<0)
So, budget deficit causes trade deficit



Saving Investment: Small Open Economy
For a small open economy, r = r*, where

r = domestic real interest rate
r* = world real interest rate
So, S – I(r*) = NX


Determination of Real Interest Rate

r
NX>0
r*
r

S

If r<r*, then S>I for capital outflow
and a trade surplus.
If r>r*, then Sand a trade deficit.

Domestic real interest rate

r*

NX<0

I(r*)
I


Fiscal Policy at Home
Real interest rate

S2
r*

S1

An increase in G or a decrease in T
results in a lower S. Now Scapital outflow and a trade deficit.

NX<0

I(r*)
Investment, Saving


Fiscal Policy Abroad
Real interest rate

S
r2*

NX<0

An increase in G or a decrease in T in
the U.S. results in a higher r* causing
S>I and a trade surplus.

r 1*

I(r*)
Investment, Saving


Increase in Investment Demand
Real interest rate

S

An increase in I(r*) results in Strade deficit.

r*
NX<0

I2(r*)
I1(r*)
Investment, Saving


Exchange Rate
Nominal exchange rate = e: the relative price of the
currency of two countries; e.g., $1 = 120 yen or 1 yen =
$0.00834
Real exchange rate = ε: nominal exchange rate adjusted
for the foreign price difference
ε = e  (P/P*)
where
P = domestic price level
P* = foreign price level


Real Exchange Rate and Trade Balance
ε
NX<0
The lower the real exchange rate, the less

expensive are domestic goods relative to
foreign goods, thus the greater is the net export.

NX>0

NX(ε)
-

0

+

NX


Determinants of Real Exchange Rate
Equilibrium value of ε is determined by:
Net Foreign Investment = Trade Balance
S – I = NX
Here, the quantity of dollars supplied for net foreign
investment equals the quantity of dollars demanded
for the net export of goods and services.


Determinants of Real Exchange Rate
ε
S-I
ε
Equilibrium real exchange rate

NX(ε)
I


Fiscal Policy at Home
Real exchange rate
S2 - I

S1 - I

ε2

An increase in G or a decrease in T
reduces S, shifting S-I line to the left.
This shift causes ε to increase, but NX
to decrease.

ε1
NX(ε)

NX2

NX1

Net export


Fiscal Policy Abroad
Real exchange rate
S1 - I

S2 - I

ε1

An increase in G or a decrease in T in
the U.S. results in a higher r* causing I
to decrease. This shift causes ε to decrease,
but NX to increase

ε2

NX(ε)

NX1

NX2

Net export


Increase in Investment Demand
Real exchange rate
S – I2

S – I1

ε2

An increase in I shifts S-I line to the left.

This shift causes ε to increase, but NX
to decrease.

ε1

NX(ε)

NX2

NX1

Net export


Effect of Trade Protectionism
Real exchange rate
S-I

ε2

Protectionism reduces the demand
for imports, increasing net export.
A higher NX line causes ε to increase,
with no net change in net export.

ε1
Here the value of foreign
trade is unchanged because
the rise in the real exchange
rate discourages exports, which

offsets the decline in imports.
NX1 = NX2

NX(ε)2
NX(ε)1

Net export


Determinants of Real Exchange Rate
From ε = e * (P/P*), write e = ε (P*/P)
Take percentage rate:
%Δe = %Δε + %ΔP* - %ΔP
%Δe = %Δε + (π* - π)
Where (π * - π) is the difference in inflation rates of the
two countries


Inflation and Nominal Exchange Rate
Countries with relatively high inflation tend to have
depreciating currencies.
Countries with relatively low inflation tend to have
appreciating currencies.


Inflation and Nominal Exchange Rate