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123
CHAPTER 6
The Open Economy
Notes to the Instructor
Chapter Summary
This chapter introduces a simple model of a small open economy in the long run. The main aims
of the chapter are as follows:
2. To provide a simple model of international flows of capital and goods, emphasizing that
these ultimately depend upon the determinants of saving and investment.
4. To explain the determination of the nominal exchange rate.
Comments
Students are interested in the open economy; this chapter provides them with the tools to think
about open economy issues. I emphasize the fact that we can figure out the trade balance before
we introduce the exchange rate into the analysis. This is often surprising to students. The chapter
questions and explain that the large open economy represents some kind of average of a small
open economy and a large closed economy. I note that we can combine the two models to obtain
a more complicated model that does apply more directly to the United States. Time permitting, it
is worth going through the large open economy case to drive home the point that we are not
misled by combining the conclusions from the closed economy and small open economy cases.
Use of the Web Site
As a hard but worthwhile exercise, students could be asked to combine the models of Chapters 3
and 6 to understand the large open economy. A good starting point is to suppose that the United
States is half the world economy and to think about Chapter 3 as a model of the world economy.
Now suppose, for example, that government spending is increased by $200 billion. This is like
an increase of $100 billion in the world economy. The Chapter 3 model can be used to figure out
124 | CHAPTER 6 The Open Economy
Use of the Dismal Scientist Web Site
Go to the Dismal Scientist Web site and download annual data since 1973 for the U.S. dollar
exchange rate against the Japanese yen, the British pound, and the Canadian dollar. Now,
download data on the Consumer Price Index (CPI) for the United States, Japan, United
Kingdom, and Canada. Compute real exchange rates by multiplying the foreign currency price
of a dollar by the CPI for the United States and then dividing by the CPI of the respective
country. Discuss how the real exchange rates have changed over time. Some economists argue
Chapter Supplements
This chapter includes the following supplements:
6-1 The Terminology of Trade
6-3 The Open Economy in the Very Long Run
6-5 The Exchange Rate and the Inflation Rate (Case Study)
6-7 Purchasing-Power Parity and Real Exchange Rates
6-8 More on the Big Mac and PPP (Case Study)
Lecture Notes | 125
!Table 6-1
!Figure 6-1
Lecture Notes
Introduction
We now have a nearly complete picture of the macroeconomy in the long run. Output is
determined by capital, labor, and technology. The price level depends on the money supply, and
the inflation rate is determined by the growth rate of the money supply. We have explained the
long-run determination of several of the variables that interest macroeconomists, and we have
The first and most important point is that virtually all economies are integrated into a
larger world economy. Economies do not exist in isolation but have extensive trading relations
with the rest of the world. Economies that trade with other economies are called open
economies. In the United States in 2010, for example, exports were $1,840 billion and imports
were $2,357 billion (13 percent and 16 percent of GDP, respectively). In other countries,
international trade is even more important.
6-1 The International Flows of Capital and Goods
The Role of Net Exports
In an open economy, we have to revise our basic national income identity to read
Y = C + I + G + NX,
where NX = net exports = exports minus imports. Net exports is the difference between
output (Y) and domestic spending (C + I + G). Remember that this equation is the equilibrium
citizens of other countries and so are a source of demand not included in domestic spending.
International Capital Flows and the Trade Balance
Our analysis of the closed economy emphasized that saving equals investment. The same is true
in the open economy if we expand our definition of saving to include saving by other countries.
Starting from
Y = C + I + G + NX
126 | CHAPTER 6 The Open Economy
finance the difference and we refer to this as negative net capital outflow.
Thus, the national income accounts identity illustrates how the international flow of funds
to finance capital accumulation and international trade in goods and services are two ways of
looking at the same question. When saving is greater than needed to finance investment, we lend
the excess to foreigners. Foreigners use this loan to purchase more goods and services from us
International Flows of Goods and Capital: An Example
Net exports must always equal net capital outflow because this relationship is an identity. The
intuition behind this relationship involves tracing out the movement of money in a series of
transactions. The example in the textbook involves Bill Gates selling a copy of the Windows
operating system to Japan and considers the set of transactions that Mr. Gates could make with
the proceeds of the sale that must always satisfy the identity.
FYI: The Irrelevance of Bilateral Trade Balances
6-2 Saving and Investment in a Small Open Economy
Capital Mobility and the World Interest Rate
When analyzing an open economy, we obviously can no longer restrict our attention to domestic
variables. In particular, world interest rates become central to the analysis, raising the issue of
whether or not such variables are independent of what goes on in the domestic economy. If we
are analyzing the economy of, say, Iceland, it is probably reasonable to suppose that changes in
the Icelandic economy have a negligible effect on world interest rates. Such an economy is
referred to as a small open economy. It is less evident that this is an appropriate assumption for a
large open economy like the United States. Nonetheless, we first consider the behavior of a
small open economy and later show that the appropriate analysis for a large open economy lies
somewhere between the small open economy model and the closed economy model that we have
already considered.
Lecture Notes | 127
!Figure 6-3
!Figure 6-4
Why Assume a Small Open Economy?
We use the assumption of a small open economy to simplify the analysis. Our intent is to build a
basic model that captures the most important features of the economy while ignoring additional
complications. For some countries, this assumption is more likely to be realistic than others. In
The Model
Apart from the assumption that r = r*, the model closely resembles our earlier analysis. As
before, we will let Y =
Y
, C = C(Y – T), and I = I(r) and take government policy (G and T) as
exogenous. The classical model presented in Chapter 3 showed that saving is then also
exogenous (
S
). The level of investment is determined simply by the investment function given
the world interest rate [I(r*)]. Combining these with the accounting identity that sets net exports
equal to net capital outflow, we obtain
How Policies Influence the Trade Balance
This model permits easy analysis of the effects of fiscal policy in an open economy. If the
government increases spending or cuts taxes, then, just as in the closed economy model, national
saving falls. If the economy starts in a position of trade balance (NX = 0), then the consequence
is a trade deficit and negative net capital outflow since there is now insufficient domestic saving
to finance domestic investment.
We might also be interested in the consequences of changes in the fiscal policies of other
countries. To understand these, we must go back to our closed economy analysis. Since we are
considering an economy that is negligible in world markets, we can view the rest of the world as
a closed economy, which means that if there is an increase in spending by the rest of the world,
Evaluating Economic Policy
Trade deficits arise when there is insufficient domestic saving to finance domestic investment.
Low levels of saving in an economy are analogous to low levels of saving by an individual; they
imply that consumption in the present is high at the expense of consumption in the future. In a
closed economy, low levels of saving result ultimately in a low capital stock, as shown by the
128 | CHAPTER 6 The Open Economy
!Figure 6-6
!Figure 6-7
!Supplement 6-4,
“Tourism and the
Case Study: The U.S. Trade Deficit
The small open economy model can help us understand the evolution of the U.S. trade deficit
during the 1980s, 1990s, and early 2000s. By using the identity that net exports equal the
difference between saving and investment, we can analyze the combination of movements in
saving and investment that gave rise to the trade deficit during this period. In the 1980s, the
deficit increased sharply at the same time that national saving declined due to the rise in the
federal budget deficit. This emergence of simultaneous deficits in both trade flows and the
government budget has been referred to as the twin deficits. After falling sharply at the start of
Case Study: Why Doesn’t Capital Flow to Poor Countries?
The U.S. trade deficit is financed by the flow of capital into the United States from foreign
countries. But many of the countries with trade surpluses are much poorer than the United
States, and so one would expect that they would be borrowers rather than lenders. Furthermore,
if capital is scarce in poor countries, then the marginal product of capital should be high,
compared to rich countries where capital is abundant. One would expect that a high marginal
product of capital in poor countries would attract capital inflows.
6-3 Exchange Rates
Our next task is to explain the exchange rate. Here, it is important to be clear on definitions.
Nominal and Real Exchange Rates
The nominal exchange rate (e) denotes the amount of foreign currency that can be bought with
$1. Equivalently, it is the price of a dollar in terms of foreign currency. The value of e is
determined in a market—the market for foreign exchange. Note that since the nominal exchange
!Figure 6-8
!Figure 6-10
!Figure 6-9
!Figure 6-11
the monetary authorities fix the value of e by standing ready to buy and sell dollars at that rate.
Managed floating is somewhere between the two. The U.S. dollar is currently floating, though
the U.S. monetary authorities do sometimes intervene in foreign exchange markets, buying and
selling the dollar in attempts to influence its value. We return to fixed exchange rates in Chapter
13; for the present, we restrict our attention to floating exchange rates.
cheap and domestic goods are relatively expensive. The opposite is true when the real exchange
rate is low.
The Real Exchange Rate and the Trade Balance
Net exports depend upon the real exchange rate. If the dollar is more valuable, imports are
The Determinants of the Real Exchange Rate
The real exchange rate adjusts to ensure that net exports equal the difference between domestic
saving and domestic investment (net capital outflow). We know that
NX(ε) =
S
S – I(r*).
Since S is fixed at
S
and r is fixed at r*, then ε must adjust to ensure balance.
We noted earlier that the exchange rate is ultimately determined in the market for foreign
exchange. When we export to foreigners, they need to acquire U.S. dollars to purchase our
goods. When we wish to import goods, we sell dollars to get other currencies. If we export more
How Policies Influence the Real Exchange Rate
Earlier, we looked at the effects of various policies on net exports and net capital outflow. We
can now consider how those policies affect the exchange rate. First, consider an expansionary
fiscal policy, which reduces national saving. This reduces net capital outflow, thus reducing the
supply of dollars and causing an appreciation of the exchange rate.
Fiscal expansions abroad, as discussed earlier, increase the world interest rate and so
reduce investment at home. This increases the supply of dollars, leading to a depreciation of the
exchange rate. Conversely, an exogenous increase in domestic investment demand (perhaps due
to domestic policies to stimulate investment) reduces net capital outflow, reduces the supply of
dollars, and appreciates the exchange rate.
130 | CHAPTER 6 The Open Economy
!Figure 6-13
!Supplement 6-5
“The Exchange
Rate and the
Inflation Rate”
The Effects of Trade Policies
There is often discussion in the news of trade policies—that is, policies directly targeted at the
trade balance. These principally take the form of tariffs (taxes on imports) or quotas (restrictions
on the quantity of imports). Perhaps surprisingly, protectionist policies of this sort are not
successful because they simply cause appreciation of the exchange rate without affecting the
The Determinants of the Nominal Exchange Rate
After considering the determinants of the real exchange rate, our next step is to think about the
nominal exchange rate. We know that
ε = eP/P*.
By now we are familiar enough with growth rates to move straight from this equation to
∆ε/ε = ∆e/e + π – π*,
Case Study: Inflation and Nominal Exchange Rates
The relationship between inflation and nominal exchange rates is evident in the data. Countries
with very high rates of inflation experience massive depreciation of their exchange rate. The
relationship is also visible for countries experiencing more moderate inflation rates.
The Special Case of Purchasing-Power Parity
From the equation
∆e/e = ∆ε/ε + (π* – π),
we can see that if the real exchange rate never changed, then movements in the nominal
exchange rate would be explained solely by differences in inflation rates. One particular and
simple theory of the exchange rate, called purchasing-power parity (PPP), suggests that the real
exchange rate should be constant through time. The argument is that the nominal exchange rate
should always adjust so that goods cost the same in different countries because, otherwise,
arbitrage could take place. For example, suppose that pizzas are cheaper in the United States
than in Canada. Then, an arbitrageur could buy pizza in the United States, ship it across the
Lecture Notes | 131
!Table 6-2
!Supplement 6-8
“More on the Big
!Figure 6-15
!Figure 6-16
!Figure 6-19
appreciated sharply. This appreciation was not a response to changes in purchasing power. PPP
is still useful, however, because it offers some guide to the long-run value of the exchange rate.
Over the long run, the real exchange rate differs from its PPP value to only a limited extent.
Case Study: The Big Mac Around the World
The Economist news magazine collected data on the price of a McDonald’s hamburger around
6-4 Conclusion: The United States as a Large Open Economy
Finally, what about the fact that the U.S. economy is not actually a small open economy but
instead a large economy whose actions affect world financial markets? As might be expected,
the appropriate analysis for the U.S. economy turns out to be a mixture of the two special cases
of the small open economy and the large closed economy. This is an example of how an
understanding of reality is sometimes easier in terms of two “unrealistic” models rather than one
more realistic model. The appendix details the working of the more complicated large open
economy model.
Appendix: The Large Open Economy
Net Capital Outflow
To think about the large open economy, we work with two basic equations:
CF(r) = S – I(r)
and
NX(ε) = CF(r),
where CF(r) is net capital outflow. The closed economy analysis sets NX = 0, implying that CF
= 0, and leaves us with an equation to determine r, S = I(r). This is the model of Chapter 3. The
small open economy sets r = r* and says that net capital outflow can take on any value at r*;
funds flow freely into and out of the country, with no effect on the world interest rate. This
means that we can substitute to get an equation determining ε : NX(ε ) = I(r*) – S. The large
open economy is between the two.
Policies in the Large Open Economy
We analyze the large open economy by considering the loanable-funds market, the CF schedule,
and the foreign exchange market.
132 | CHAPTER 6 The Open Economy
!Figure 6-20
!Figure 6-21
A fiscal expansion reduces saving in the world loanable-funds market, increasing the
world interest rate. At a higher interest rate, we wish to carry out less investment, both at home
and abroad. The decrease in net capital outflow reduces the supply of dollars and so causes the
exchange rate to appreciate. The trade balance falls.
An increase in domestic investment demand also pushes up the world interest rate, so net
capital outflow falls. Again, there is an appreciation of the exchange rate and a decline in net
LECTURE SUPPLEMENT
6-1 The Terminology of Trade
In discussing the international flows of goods, services, and capital, we have made some important
simplifications. We have used the terms “net exports” and “trade balance” interchangeably, although in
practice these terms sometimes differ slightly in meaning. More importantly, we have also shown how the
simple income identity requires that net exports equal net capital outflow, although in practice this is not
precisely correct. These simplifications helped us highlight the important features of the analysis without
bringing in too much detail. This supplement provides some additional background on concepts relating to
the international flow of goods, services, and capital.
Another simplification we have made is to equate net exports with net capital outflow. Because
residents of a country may earn interest on assets held abroad and/or earn wages from working abroad,
national income may differ from GDP. In addition, because residents of a country may give gifts to and/or
receive gifts from foreigners, their income again may differ from GDP. These net factor payments and net
foreign transfer payments are important in measuring domestic saving and thus in measuring the
difference between domestic saving and domestic investment. Since the difference between domestic
saving and domestic investment equals net capital outflow, these payment flows have implications for the
S – I = NX + Net Factor Payments + Net Foreign Transfers
or
Net Capital Outflow = Current Account.
The modified identity thus relates a broader measure of trade flows—known as the current account—
to net capital outflow.
One final term sometimes used in place of net capital outflow is the capital account. When we
